Active Funds on the Defensive

There is a difference between saying that index investing is always sensible and saying it is always best

John Rekenthaler 24 October, 2018 | 12:49PM
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Fund management targets

The general view of indexing, that it is consistently a sound strategy if offered at low cost, is correct. That does not mean, however, that actively managed funds are necessarily inferior. There is a difference between saying that indexing is always sensible and saying it is always best.

To start, the firmest conclusions about indexing have come from studying a single fund type: diversified US equities. Bonds, property, asset allocation, and international stocks have received far less research. Trickier yet are those that hold multiple asset classes, such as target-date or balanced funds.

This emphasis on US equity funds leads to a subconscious sleight of hand. Academic studies show that active domestic stock funds have struggled to keep pace with the indexers. There hasn’t been much coverage of other fund varieties, but, at a first glance, the anecdotal evidence looks similar. Voila! Indexing works everywhere.

While I accept that this sleight of hand exists I also must grant that the burden of proof lies with active management. It is one thing to recognise that lessons drawn from one investment sector may not translate fully to another. It’s another to demonstrate, specifically, where the opportunities lie. Without that step, it’s difficult to criticise the public’s current approach of “when in doubt, index”.

Studies backing active management have also focused too much on “alpha”. Alpha is commonly used to mean “manager skill”, the alpha measurement is nowhere near that precise. It captures when a fund’s risk-adjusted performance deviates from that of its benchmark, and whether that is skill, luck, or the residue from an imperfectly fitted benchmark is anybody’s guess.

Funds Often Killed Off Too Early

It is commonly recognised that if firms scrub their expired funds, their performance results will be biased upward because only the bad die young, which is known as survivorship bias. Cleverly, a researcher considered the reverse. What if fund companies were hurting their results by killing their funds inopportunely before changing market conditions could boost their fortunes?

Apparently, that is indeed the case. Not only do fund investors mistime their purchases and sales, but fund managers also do. They launch funds when those investment styles are fashionable, then shut them down when they are unpopular and due to rebound.

However, while such a finding compliments active managers’ abilities, it does little for investors’ returns. The improved performance was only theoretical – the results that the funds would have recorded had they remained alive for shareholders to own. But they did not remain alive, and shareholders did not own them. Such are most of the defences for active managers.

The remaining support for active management involves bettering the odds. Investors need not purchase just any fund, after all. They can seek funds with strong recent records, those with high active share scores – ie. that don’t just hold mimic the index – those with low turnover rates, and so forth. Researchers have found many attributes that increase the odds for active investors.

To replicate the studies, every stock may be bought, at least by professional managers. But nobody will purchase every fund; the attempt is impractical. Thus, even if the theoretical fund research is powerful and identifies a persistent factor, the investor who puts it into practice could fail through bad luck.

 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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John Rekenthaler

John Rekenthaler  John Rekenthaler is vice president of research for Morningstar.