Morningstar Advisor - February/March 2011 - (Page 40)

Spotlight It’s More About Costs Than Being Active or Passive By Russel Kinnel Simply choosing to index doesn’t get you very far. Focusing on low costs does. In the age-old active-versus-passive debate, it’s funny how little is written about how index funds and actively managed funds have actually performed. I’ve run a few studies that suggest that good performance is not about active versus passive. It’s about low costs versus high. And by the way, low costs are not necessarily a vote for passive investments. I set out to test how each group has performed during the past 10 years in a study that was not biased by survivorship. The past decade has seen huge numbers of funds killed off, so to ignore that segment would be a big mistake. My chief test here was success ratio. The success ratio tells you what percent of a group survived and outperformed its peers. I started with the universe of funds that were in existence as of Jan. 1, 2001. Then, I divided that universe into active and index groups. I included all share classes in my tests. There were 542 index funds at the beginning of the period. Of those, 133 were still standing 10 years later and had outperformed their peers, producing a 25% success ratio. Another 246 of them, or 45%, survived but underperformed. Finally, 163, or 30%, of the original index funds were liquidated or merged away during that time period. There were 15,789 actively managed funds, including all share classes, to start the period. Of those, 3,855 outperformed during the next 10 years, producing a success ratio of 24%. Thus, the actively managed funds had roughly the same success ratio as the index funds. A total of 4,186 of the actively managed funds, or 27%, survived but underperformed. Another 7,748 of them, or 49%, were killed off. Here we see a dramatic difference between active and passive funds. Nearly half of the actively managed funds were killed off, whereas 30% of index funds didn’t survive the ensuing 10 years. One reason for this may be that active funds are more likely to dramatically underperform. Also, people tend not to blame a fund company if an index fund underperforms its peers as long as it closely tracks its benchmark. Thus, fund companies may have less desire to sweep index laggards under the rug. How the Largest Funds Performed I looked at the 10 largest index funds and the 10 largest active funds based on their assets from 10 years ago that are still in existence today (Exhibit 1). Eight of the 10 largest index funds performed well enough to land in the top half of their categories. The 10 index funds averaged an annualized 3.2% return over the period. For the actively managed funds, six of the 10 outperformed in their categories. The 10 active funds averaged an annualized 1.9% gain.While the category mix of the two top-10 lists was slightly different, both lists had nine stock funds and one bond fund. A deeper look nicely illustrates the risk and reward choice between index funds and actively managed funds. All 10 index funds finished in the second or third quartiles for the 10-year period. However, four actively managed funds boasted top-quartile returns and one was a bottom-quartile performer. Three actively managed funds lost money during the 10year period, but none of the index funds did. In short, the index funds were much less likely to suffer really poor relative returns than actively managed offerings. That’s a major plus. But the index funds were also less likely to post topnotch returns than were actively managed funds. Low Cost Versus High Cost Another angle to take is to see how the largest funds have performed. After all, investors are far more likely to invest in strong-performing funds from the biggest fund companies. Rather than fixating on active funds versus 40 Morningstar Advisor February/March 2011

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2011

Morningstar Advisor - February/March 2011
Contents
Contributors
Letter From the Editor
First, Do No Harm
Do You Use Active or Passive Investment Strategies?
Best of Both Worlds
How to Build an Index
Accountable Investor
Nice Guys Finish First
Four Picks for the Present
Investment Briefs
A New Guardrail Against Risk
Tech Loosens the Purse Strings (a Bit)
It’s More About Costs Than Active or Passive
Play Your Stars
In Between Active and Passive
Selling Beta as Alpha
The Weighting Game, and Other Puzzles of Indexing
Leaving the Nest
Redefining Credit Risk
Another Vote for Market-Based Credit-Risk Measures
Big Opportunities in Small-Cap Stocks
Benchmarks? What Benchmarks?
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
VA Sales Slide, but Assets on the Rise
Indexing’s Lunatic Fringe

Morningstar Advisor - February/March 2011