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By Ben Johnson, CFA and Christian Charest | 09-07-2017

A better way to gauge active managers' performance

Comparing active funds to a composite of passive funds, rather than an index, better reflects investors' reality, says Morningstar's Ben Johnson.

Christian Charest: For Morningstar, I'm Christian Charest. Morningstar has been saying for a while now that high fees are a detractor to fund performance, and that picking funds with lower fees helps your chances of outperformance. And now Morningstar has just added fuel to that fire, and I am here with Morningstar's Director of Global ETFs, Ben Johnson to talk about it.

Ben, the research I was referring to is the Morningstar Active/Passive Barometer. Can you give us an idea of what that research does?

Ben Johnson: So, within our Active/Passive Barometer, what we do is we compare the performance of actively managed funds in a given category versus a composite of their passively managed peers. For example, on our U.S. Large Blend category, we'll compare the performance of active managers relative to a mashup of index mutual funds and exchange-traded funds that track U.S. total stock market indexes or the S&P 500 index.

Now what this is intended to do is to reflect investors' reality, to reflect their opportunity set when it comes to selecting among the whole spectrum of funds within a given category. What it also reflects is the actual net-of-fees performance of those passive funds, which is important because others have done similar work, but they've used the index performance itself, which doesn't reflect the real costs and the messy reality that faces index portfolio managers as they seek to track their benchmark. What it also avoids is the potential for cherry-picking. Depending on the index that you select, active managers can look quite good or they can look quite poor because there are important differences in index construction.

So, by creating an amalgam of different funds tracking different benchmarks, we think we solve for this, and again we reflect very pragmatically the average investors' experience -- the experience of the average invested dollar in both actively managed funds as well as passively managed ones.

Charest: Right, because indexes aren't free. Now the research was done on U.S. funds, but some of the findings are universal -- namely as I mentioned earlier, the fact that low-cost funds have a better chance of outperformance.

Johnson: Absolutely. So, there are two key signals that we're able to derive from this work. The first is that active security selection is a very difficult exercise. That over a very long period of time, managers across most categories either fail to survive to see the end of the period -- their funds are either closed or merged away -- and even among those that do survive from beginning to end of period, many failed to thrive. When I say thrive, specifically what I mean is those managers failed to produce performance that exceeds that of their average passive peer.

The other signal that rings through loud and clear, and is also very intuitive, is that low-fee funds have had greater odds of success versus high-fee funds, that when it comes to selecting active managers you should place intense scrutiny on that fee level. Because intuitively that fee level is a self-imposed hurdle for that manager, and the higher they set that hurdle, the lower the odds are that they will ultimately surmount that hurdle over a long period of time, given what has been referred to by many as the tyranny of compounding costs.

Charest: The research also found out that style drift -- the idea that some managers may stray from their stated goal -- is one of the elements that actually helps active managers.

Johnson: So, what we see in shorter periods is that active managers can be rewarded for sort of colouring outside the lines. So, if you think of the Morningstar Style Box. A large-cap value manager is going to be plotted in the top left corner, but that's not going to say necessarily that all of the stocks that they add to their portfolio will reside in that particular square within the broader box. They may stray further down the market capitalization spectrum and invest in mid- and small-cap stocks. They may stray from left to right and invest in blend and growth stocks. And depending on where we are in any prevailing market environment, that manager may be rewarded for colouring outside the lines, which anyone who might be in a sort of elementary-school setting would think would not be something worth rewarding. But being style impure can show either skill or simply just pure luck on the part of certain active security selectors who aren't as rigidly confined to their segment of the Morningstar Style Box as their index peers are by definition.

Charest: Lot of interesting findings in that research. Ben thank you very much for sharing all this with us today.

Johnson: Thanks for having me.

Charest: For Morningstar, I'm Christian Charest. Thank you for watching.

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