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A Twisted Debate: Active vs. Passive Is Largely A Smokescreen
Like Old Joe, I found Morningstar’s Don Phillips article on the active-passive controversy interesting; it contained both elements of fairness and balance.
But, but it was incomplete and shallow in its analyses of the debate.
First, I think very highly of Don Phillips and the Morningstar organization that he helped create as one of its founding fathers. Both he and the Morningstar firm are knowledgeable, fair-minded, and trustworthy. I often exploit their resources.
However, in the referenced article, Mr. Phillips’s work was unfinished in that it did not probe deep enough to really test some of the main components of the active-passive mutual fund debate. Here are a few of the shortcomings and issues that I discovered in the article.
One overarching cautionary factor that must always be considered when assessing Morningstar research is that the outfit’s primary purpose is to uncover superior actively managed mutual funds and stocks. Their main raison d’etre (in addition to making a profit) is to identify superior fund holdings. So Morningstar has a financial incentive to highlight active fund management. I freely acknowledge that Morningstar does yeomen work to enforce this incentive.
Phillips erects an easily destroyed false strawman to advance his goal. He says “Although the public perception that all active managers trail the market is false”. That’s a strawman target; we know better. I propose that almost all seasoned investors fully realize that some small fraction of actively managed funds will deliver superior results (positive Alpha) for extended periods. The problematic issue is to identify this rare group a priori. Morningstar evaluation methods have always struggled and often failed with this assignment.
The Phillip’s study is based solely on category ranking, a mere ordering of funds within the cohort. This approach simply does not go far enough in the assessments. The returns distribution curve is asymmetric around the market return normal, and mere ranking does not capture that asymmetry.
For example, in any given year, it is likely that about one-third of actively managed funds will generate excess returns relative its benchmark. These successful entries struggle to gain a few percentage points in superior performance. In general, the two-thirds underperforming funds generate sub-par results of a larger magnitude. Hence, when evaluating on actual investor rewards, active mutual fund management is an overall Loser’s game; the odds are not tilted to favor the individual investor.
Phillips reinforces the John Bogle argument that costs not only matter, they matter greatly. Honest Index funds, not some active fund masquerading as an Index product, but having high turnover and high costs, enhance the odds for a successful portfolio. Rick Ferri’s recent book emphasizes that as the percentage of active funds in a portfolio increases, the likelihood of producing excess Alpha above an Index benchmark dramatically decreases. Here is a Link to a Morningstar interview conducted by Scott Burns with Ferri:
In a sense, the Phillips piece is an advertisement for low cost Vanguard products.
Finally, examine the table that compares Vanguard Index rankings against Vanguard actively managed products. Except for the longest 15-year period, the rankings are nearly identical. Certainly the costs are not. The natural question is: “What is the individual investor getting for the incremental cost of active management?” The answer seems to be “nothing” except for the 15-year timeframe. That data point is such an outlier that I suggest it should be revisited searching for perhaps an error. It is either an error or an anomaly.
So, I believe that the Phillips article was fair and balance, but it did not go far enough in its assessment. In the end, it is delivered returns that matter most, not just ranking within a category.
Interestingly, none of them take taxes into consideration. I guess this could be very unpleasant for the proponents of active management. Sometimes it is possible to overcome this hurdle, but at least one should appreciate the existence and significance of this problem.
Comments
Like Old Joe, I found Morningstar’s Don Phillips article on the active-passive controversy interesting; it contained both elements of fairness and balance.
But, but it was incomplete and shallow in its analyses of the debate.
First, I think very highly of Don Phillips and the Morningstar organization that he helped create as one of its founding fathers. Both he and the Morningstar firm are knowledgeable, fair-minded, and trustworthy. I often exploit their resources.
However, in the referenced article, Mr. Phillips’s work was unfinished in that it did not probe deep enough to really test some of the main components of the active-passive mutual fund debate. Here are a few of the shortcomings and issues that I discovered in the article.
One overarching cautionary factor that must always be considered when assessing Morningstar research is that the outfit’s primary purpose is to uncover superior actively managed mutual funds and stocks. Their main raison d’etre (in addition to making a profit) is to identify superior fund holdings. So Morningstar has a financial incentive to highlight active fund management. I freely acknowledge that Morningstar does yeomen work to enforce this incentive.
Phillips erects an easily destroyed false strawman to advance his goal. He says “Although the public perception that all active managers trail the market is false”. That’s a strawman target; we know better. I propose that almost all seasoned investors fully realize that some small fraction of actively managed funds will deliver superior results (positive Alpha) for extended periods. The problematic issue is to identify this rare group a priori. Morningstar evaluation methods have always struggled and often failed with this assignment.
The Phillip’s study is based solely on category ranking, a mere ordering of funds within the cohort. This approach simply does not go far enough in the assessments. The returns distribution curve is asymmetric around the market return normal, and mere ranking does not capture that asymmetry.
For example, in any given year, it is likely that about one-third of actively managed funds will generate excess returns relative its benchmark. These successful entries struggle to gain a few percentage points in superior performance. In general, the two-thirds underperforming funds generate sub-par results of a larger magnitude. Hence, when evaluating on actual investor rewards, active mutual fund management is an overall Loser’s game; the odds are not tilted to favor the individual investor.
Phillips reinforces the John Bogle argument that costs not only matter, they matter greatly. Honest Index funds, not some active fund masquerading as an Index product, but having high turnover and high costs, enhance the odds for a successful portfolio. Rick Ferri’s recent book emphasizes that as the percentage of active funds in a portfolio increases, the likelihood of producing excess Alpha above an Index benchmark dramatically decreases. Here is a Link to a Morningstar interview conducted by Scott Burns with Ferri:
http://quicktake.morningstar.com/widget/VideoPlayer.aspx?vid=352437
In a sense, the Phillips piece is an advertisement for low cost Vanguard products.
Finally, examine the table that compares Vanguard Index rankings against Vanguard actively managed products. Except for the longest 15-year period, the rankings are nearly identical. Certainly the costs are not. The natural question is: “What is the individual investor getting for the incremental cost of active management?” The answer seems to be “nothing” except for the 15-year timeframe. That data point is such an outlier that I suggest it should be revisited searching for perhaps an error. It is either an error or an anomaly.
So, I believe that the Phillips article was fair and balance, but it did not go far enough in its assessment. In the end, it is delivered returns that matter most, not just ranking within a category.
Best Regards.
http://www.morningstar.com/advisor/t/70867036/yes-there-are-good-active-funds.htm
Interestingly, none of them take taxes into consideration. I guess this could be very unpleasant for the proponents of active management. Sometimes it is possible to overcome this hurdle, but at least one should appreciate the existence and significance of this problem.