Learn To Invest
Stocks Special Reports LICs Credit Funds ETFs Tools SMSFs
Video Archive Article Archive
News Stocks Special Reports Funds ETFs Features SMSFs Learn
About

News

A recipe for better investment predictions

Ben Johnson, CFA  |  05 Sep 2018Text size  Decrease  Increase  |  
Email to Friend

An understanding of inside and outside forecasting and the intrinsic fees-performance connection are among the powerful investor lessons of Morningstar's Active/Passive Barometer.

In his book Thinking, Fast and Slow, Nobel Prize winning psychologist Daniel Kahneman discusses how he stumbled upon two different approaches to forecasting.

Discovered while he was working for Israel’s Ministry of Education, Kahneman and his long-time collaborator, Amos Tversky, ultimately branded these two schools of forecasting “the inside view” and “the outside view.” 

The inside view is deeply personal. In constructing a forecast based on the inside view, we focus very narrowly on our own unique experiences and situation and extrapolate from there. (For example, I’m an above-average driver with a squeaky-clean driving history about to go on a short trip in fair weather. The odds of me getting in a fender bender are almost nil.)

On the other hand, a forecast based on the outside view starts with a survey of the broader population and is refined based on any specifics regarding the circumstances. (Start with the odds of any driver getting in a fender bender regardless of driving history, the distance travelled, or weather conditions, and go from there.)

Kahneman author Nobel economy behavioural

 

Daniel Kahneman mused on forecasting approaches in his book

The outside view is anchored to a base rate. Kahneman explains the concept of base rates in “Thinking, Fast and Slow”:

“…[I]t provided a reasonable basis for a baseline prediction: the prediction you make about a case if you know nothing except the category to which it belongs. This should be the anchor for further adjustments. If you are asked to guess the height of a woman and all you know is that she lives in New York City, for example, your baseline prediction is your best guess of the average height of women in the city. If you are now given case-specific information—that the woman’s son is the starting centre of his high school basketball team—you will adjust your estimate.”

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. I’ll share with you some base-rate data that is specific to success rates among active fund managers, and how investors can work from the outside to begin to zero in on winners.

Morningstar Active/Passive Barometer

In 2014 I, along with some of my colleagues in our manager research group, 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.

This is a semi-annual report that measures the performance of US active managers against their passive peers within their respective categories. it measures active managers’ success relative to the actual, net-of-fee performance of passive funds, rather than an index, which isn’t investable.

For example, an active manager in the US large blend Morningstar 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 “passive” 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.

A fairer active-passive comparison

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. In addition, the success rate for active managers can vary depending on one’s choice of benchmark.

For example, the rate of success among US small-blend managers may vary depending on whether one uses the S&P SmallCap 600 or the Russell 2000 Index as their 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 we 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 of 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 whose returns exceed 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 at the end of June 2008, the starting point for our latest study.

We expect that the number of categories we include in this study will expand over time. In this latest iteration we have added seven new categories.

We also 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.

The link between fees and performance

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. Higher cost funds were more likely to underperform or be shuttered or merged away. Lower-cost funds were more likely to survive, and enjoyed greater odds of success.

The picture painted by this research is clear: 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.

This article originally appeared on Morningstar.com, where the full mid-year 2018 Morningstar Active/Passive Barometer report is available.

More from Morningstar

• Recession risks on the rise

• RBA holds rates at 1.5pc, as expected

Make better investment decisions with Morningstar Premium | Free 4-week trial

 

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.

Email To Friend