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How investors can boost odds of picking winning managers

Ben Johnson, CFA  |  26 Mar 2018Text size  Decrease  Increase  |  
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With two broad schools of thought on investment forecasting--espousing an "inside view" versus an "outside view"--Ben Johnson from Morningstar's Chicago office explains which approach is more successful and why.

Depending on the problem at hand, starting from the outside and working in may be a recipe for better predictions and, thus, better decisions. I would argue that this approach has a multitude of applications within the realm of investing.

Morningstar Active/Passive Barometer

In 2015, I, along with some of my colleagues, began working on a project that would more systematically measure base rates on investors’ behalf with respect to selecting successful active managers in a given Morningstar Category. 

Specifically, we were looking to answer this question: If an investor were to select an actively managed fund at random from a particular category, what are the odds that fund will survive and outperform its passive peers in any given time period? The product of our efforts is the Morningstar Active/Passive Barometer.

The Active/Passive Barometer is a semi-annual report measuring the performance of US active managers against their passive peers within their respective categories. The report is unique in the way it measures active managers’ success relative to the actual, net-of-fee performance of passive funds rather than an index, which isn’t investable.

We measure active managers’ success relative to investable passive alternatives in the same category. For example, an active manager in the U.S. large-blend category is measured against a composite of the performance of its index mutual fund and exchange-traded fund peers.

Specifically, we calculate the equal- and asset-weighted performance of the cohort of index-tracking options in each category that we examine, and we use that figure as the hurdle that defines success or failure for the active funds in the same category.

The magnitude of outperformance or underperformance does not influence the success rate. However, these data are reflected in the average return figures for the funds in each group, which we report separately.

We believe this is a better benchmark because it reflects the performance of actual investable options and not an index. Indexes are not directly investable. Their performance does not account for the real costs associated with replicating their performance and packaging and distributing them in an investable format.

Also, the success rate for active managers can vary depending on one’s choice of benchmark. For example, the rate of success among US large-blend managers may vary depending on whether one uses the S&P 500 or the Russell 1000 Index as the basis for comparison.

By using a composite of investable alternatives within funds’ relevant categories as our benchmark, we account for the frictions involved in index investing (such as fees) and mitigate the effects that might stem from cherry-picking a single index as a benchmark. The net result is a far fairer comparison of how investors in actively managed funds have fared relative to those who opted for a passive approach.

We measure each fund’s performance based on the asset-weighted average performance of all its share classes in calculating success rates. This approach reflects the experience of the average dollar invested in each fund.

We then rank these composite fund returns from highest to lowest and count the number of funds with returns exceeding the equal-weighted average of the passive funds in the category.

The success rates are defined as the ratio of these figures to the number of funds that existed at the beginning of the period. Given this unique approach, our field of study is narrower than others, as the universe of categories that contained a sufficient set of investable index-tracking funds was fairly narrow 10, 15, and 20 years ago. We expect that the number of categories we include in this study will expand over time.

Also, we cut categories along the lines of cost. Cost matters. Fees are one of the best predictors of future fund performance. We have sliced our universe into fee quartiles to highlight this relationship.

Actively managed funds have generally underperformed their passive counterparts, especially over longer time horizons. In addition, we found that failure tended to be positively correlated with fees (that is, higher-cost funds were more likely to underperform or be shuttered or merged away, and lower-cost funds were likelier to survive and enjoyed greater odds of success). Again, fees matter. They are one of the only reliable predictors of success.

I think the Active/Passive Barometer is a useful starting point for investors looking to take the outside view when it comes to picking successful active managers. As for working from the outside in, it is little surprise that focusing on fees is the best way to boost your base rate.

Developed by Morningstar in the US as an analysis tool for funds in that market, there is currently no Australian version of the Active Passive Barometer. However, many of the same principles discussed above are applied by the local manager research team.

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Ben Johnson is director of passive funds research at Morningstar, based in Chicago.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication

is director of global exchange-traded fund research for Morningstar.

© 2020 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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