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This study addresses, and attempts to resolve, several empirical issues that commonly impinge on the analysis of active vs. passive investing, specifically in relation to actively or "passively" managed mutual fund portfolios. First issue: Passive investing in the U.S. equity market is generally equated with investing in equity-based index funds. The performance of this approach is too often represented by a single index - the Standard & Poor's 500 Index. Representing the broad U.S. equity market by use of one large-cap equity index dramatically simplifies (and distorts) the complexity of the U.S. market, or virtually any equity market for that matter. Rather than assume that the U.S. equity market is represented by a single index, this study calculates the average return of major U.S. equity indexes within each of the nine Morningstar style boxes (large-cap value, large cap blend, large cap growth, mid cap value, mid cap blend, mid cap growth, small cap value, small cap blend, and small cap growth). The averaged returns of several major equity indexes are then used as the performance benchmark against which actively managed funds within the same style box are compared. Second issue: Most, if not all, active vs. passive investing studies tally the number of funds that beat their respective index benchmark over some specific time frame. This approach has the unfortunate effect of equally weighting funds. Clearly, however, a fund with $30 billion in assets that outperforms its benchmark index is more important than an "outperforming" fund with only $30 million in net assets. It must be agreed that, when studying this issue, the ultimate measure of relevance is how the end-user-the investor-is impacted. As such, measuring the asset total that outperforms this or that index is the more correct measure of "impact." Therefore, rather than only count the number of funds which over- or under-perform a particular equity benchmark this study also calculated the total mutual fund assets (within each distinct style box) that outperformed their comparable benchmark indexes. Importantly, this approach also resolves an additional issue, namely what to do with mutual funds that are sold via multiple share classes. The removal of "redundant" share classes avoids the problem of over-weighting the performance of funds with multiple share classes. However, as this study is seeking to discover how many dollars outperformed a target benchmark, it doesn't matter if the assets were in A shares, B shares, C shares, etc. All that matters to the individual investor is how their fund (regardless of share class) performed relative to appropriate benchmarks. The one exception was the exclusion of LW, or load-waived, shares. This hypothetical share class was added to the Principia database in 2005, but has no assets associated with it. Data The first task was developing aggregated, index-based performance benchmarks against which the performance of actively managed equity mutual funds can be appropriately measured. Performance data from five different index makers were utilized in this part of the study, including Dow Jones, Morningstar, Russell, Standard & Poor's, and Wilshire. Year-end performance data for U.S. equity indexes were obtained from Morningstar's Principia software, specifically the January discs from 2002 through 2006.
The aggregated performance of U.S. large cap value indexes, large cap blend indexes, and large cap growth equity indexes is reported in Figure 1. The benefit in calculating the average return for the various indexes is manifested by the differential between the high and low return in each category. In 2001, for instance, there was a 612 basis point differential between the best performing large cap value index (Russell 1000 Value) and the worst performing index (S&P 500 / Citigroup Value, formerly Barra Large Cap Value). There were even larger differentials among large cap growth indexes. Performance differentials of this magnitude will have a sizable impact on any comparison of actively managed funds against passive indexes. |
Few topics in the field of finance have generated as much interest and spirited debate as the issue of active versus passive investing. Empirical evidence in support of the superiority of passively managed portfolios is persuasive (See, for example, Davis, 2001; Arnott, Berkin and Ye, 2000; Sorensen, Miller and Samak, 1998; Carhart, 1997; Gruber, 1996; Malkiel, 1995; or Brinson, Hood and Beebower, 1995). Conversely, equally sound empirical and/or logical evidence in defense of the value of active portfolio management has been presented (See, for example, Pastor and Stambaugh, 2002; Wermers, 2000; Elton, Gruber and Blake, 1996; or Etzioni, 1992). Moreover, "behavioral" arguments in favor of actively managed funds have been offered (Timbers, 1997).
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