From the December 2007 issue of Wealth Manager Web • Subscribe!

Gray Areas

Indexing has been known to rouse strong opinion, both pro and con. Some accept it unconditionally, and others reject it entirely. But many--perhaps most--investors steer clear of absolutes and own both active managers and index funds, or at least allow for the possibility. Muddled thinking? Perhaps, although a recent study suggests there's cause for keeping an open mind.

Results, in other words, may vary when it comes to analyzing active and passive funds. That's the message in a research study co-authored earlier this year by Matthew Rice and Geoffrey Strotman of the Chicago investment consultant DiMeo Schneider & Associates. "The Next Chapter in the Active vs. Passive Management Debate" (available at crunches the numbers in a way that may surprise even the most dedicated fans of indexing or active management.

Consider, for instance, one of the bedrock arguments in support of indexing: The benchmark beats the average active manager over the long run. Yes, but as the DiMeo Schneider paper reminds, that's the opening statement to a longer story. True, over the past 10 years, indices have generally enjoyed superior performance over the median active manager during bull markets. But during the periods when the bears held sway, the median active manager outperformed the respective indices on a relative basis, the study finds.

Rice and Strotman also report that over the past decade, 90 percent of top-quartile active mutual funds suffered at least one three-year period in the bottom half of their peer-group performance ranking. Meanwhile, the overall break-even point for active versus passive funds for 17 investment strategies is the 48th percentile, lending support to the idea that indices are tough to beat. But looking at the 17 strategies individually shows that the break-even point varies quite a bit, implying that indexing holds more--or less--promise, depending on the market under discussion.

The point is that weighing active versus passive management isn't always cut and dried. Yes, index funds are sometimes the superior choice, Rice told Wealth Manager in a recent interview. No wonder, then, that DiMeo Schneider uses passive management in its oversight of some $25 billion of assets for its institutional and high-net-worth clients. But the passive choice isn't exclusive. Indexing, for all its power, isn't always and everywhere the compelling choice, Rice adds. Deciding when it's better, and when it's not, he explains, is a function of several factors, including the fund choices, the fees and the dynamics and challenges of the target market.

Pre-emptively choosing active or passive may make portfolio management easier, but smart investing implies keeping an open mind, the firm's study suggests. For some thoughts on why, we recently talked with Rice, a principal at DiMeo Schneider who holds a CFA.

Your research finds that active managers typically underperform their respective indices during bull markets and outperform in bear markets. Why?

There are various reasons. One is that active managers hold cash, and so they're buying and selling stocks. The cash position might be 3 percent cash, it might be 10 percent. But holding cash when markets are rising is a problem. Conversely, when markets go down, holding cash helps outperform the index.

Another reason: Indices tend to be momentum driven. The bigger get bigger in cap-weighted indices. At one point, ExxonMobil was a massive holding in the Russell 1000 Value--I think it was as much as 8 or 9 percent, if not more. A manager who underweighted Exxon was at a higher risk of underperforming when the stock is going gangbusters.

Your study finds that the trend of active outperformance in bear markets and underperformance in bull markets held across various asset classes, including domestic and foreign stocks, bonds, REITs, and so on.

It did, although we're talking here of the median manager. If we break it out for top-quartile managers, you might not see underperformance against the index. Even so, the trend is still true in terms of relative performance in that the top managers tend to do better in down markets than in up markets.

What lessons does your study offer for designing and managing multi-asset-class portfolios?

One is that the active/passive debate shouldn't focus on active managers versus indices. Rather, it should be active managers versus index funds. The reason is that index portfolios have trading costs, management fees and cash flows. Depending on the target market, indexing may be relatively easy and cheap--large-cap U.S. equity, for instance. However, some categories can be implicitly or explicitly expensive to index, such as emerging markets and U.S. intermediate bonds. In 2002, for example, the Vanguard Total Market Index Fund underperformed its bogey, the Lehman Aggregate Bond Index, by 200 basis points because there was a shortage of liquid energy and telecom bonds at the time.

If the only choice for an index fund is one with an expense ratio of 50 basis points or higher, paying an active management fee might be worth considering.

The bigger factor is finding good active managers. But if you're looking for managers who will outperform an index, and you're defining outperformance in terms of three to five years, you're going to fail. Our study shows that 90 percent of ten-year, top-quartile managers across 17 asset classes fell below the median return over an interim three-year period.

And that suggests...

You'll end up hiring managers when they're hot and firing them when they're not. The key is understanding your manager and the investing process. Before you hire a manager, you should know when he's likely to outperform and underperform. Sometimes people blame the rooster for the sun coming up, or they give the rooster credit for the sun coming up. For example, some managers avoid certain sectors, like energy or utilities. It's important to know such things. If you know your managers and understand what they're doing, you're more likely to stick with them during those inevitable lulls. Virtually every manager will have lulls--it's when, not if.

Your study identifies the general break-even point for index-based versus active manager-based portfolios across various asset classes at the 48th percentile. The implication: Use index funds unless you're confident you can find active managers who will perform better than the 48th percentile.

That's been the case if you look at the last 10 years without adjusting for survivorship bias. Of course, it varies from category to category. For example, for midcap value and large- cap value the median manager struggled [compared to the index]. In other cases, like large-cap growth, the median manager did well. But if you look at the next 10 years, these numbers will not repeat; it could be the exact opposite.

Ultimately, chasing alpha is a zero sum game around the market's return. For every alpha taker in active management, there's an alpha giver. The extraordinarily bad managers are providing the alpha opportunities for the takers. The one thing that makes me feel pretty good about active management is that there have been, historically, extremely bad managers and that means that someone else is making money around the market. If there are enough extremely bad managers, and you can avoid them, you'll increase your probability of success [for picking good managers].

As important as it is to find good managers, it's more important to avoid bad managers. If you're hiring an active manager, you must think there's at least a 50 percent probability that he'll outperform. The problem is that you need to have a higher confidence than 50 percent--you need 75 percent, 85 percent, 95 percent. And that confidence doesn't come from just looking at historical numbers. You have to understand the reasons why you think a manager will do well going forward. Does the manager have some proprietary capability? Does he have access to information that others don't have? Is the manager simply smarter?

What do you make of the various studies that find that active managers have a tough time beating the market?

The probabilities are that the longer the time period, the lower the probability that the active manager will add value. Over the long haul, it's about 50/50--half of active managers outperform, half underperform. If you factor in a 1 percent fee over time, the outperformance ratio slips further. In fact, adding 1 percent of outperformance over the market [in the long run] requires skill. If you factor in a 1 percent fee, and the expected alpha's 1 percent, you'll need that skillful manager just to break even.

Past performance is a poor predictor of future performance, but past fees are a great predictor of future fees. You should seek out those managers with low average fees because the probability of success dramatically increases with lower fees.

Sounds like an argument for index funds.

Index funds, or low-cost active managers. Another option: Enhanced index funds with low tracking error to the benchmark with relatively low fees and a high information ratio.

The bottom line: If you're paying a sizable fee every year, it's a tough road to hoe over longer periods.

But we don't worship at the altar of passive managers. This is all about trying to maximize your probability of success. First and foremost is getting the asset allocation right. Second, make sure you don't bleed alpha by selecting the wrong managers. It's more important to avoid the mistakes than it is to pick the very best managers.

JAMES PICERNO ( is senior writer at Wealth Manager.

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