Almost every Morningstar Category offers the choice of actively or passively managed funds. Presumably, some categories are better suited for active management than others. What’s an investor to do? Where should active funds be used, and where should they not?

Many articles have attempted to answer those questions. Some are based on intuition: “Index in Category A because its marketplace is efficient, but consider investing actively in Category B because its sector is less efficient.” Those claims can be discarded. Instinct may work for affairs of the heart, but it is of no use for investing.

Articles that rely on evidence, by running the numbers, would seem to be on firmer ground. However, with this particular topic, the data rest on sand.

Does Theory Work in Reality?

The natural approach when running the numbers is to sort fund categories by their funds’ success ratios. That is, for a given time period, calculate what percentage of each category’s funds beat a relevant investment index; for example, small-cap funds would be compared with a small-cap index. Consider investing actively in categories that have high success ratios, for example, exceeding 60%. Conversely, the prudent course is to index in categories that have low success ratios.

That sounds sensible. Unfortunately, there is a very large catch, because a category’s success ratio depends upon another factor. The ratio is affected by relative performance; that is, by how the category’s total returns during the study’s time period compare with the returns of other, related categories. Strong category performance hurts active management’s score, while weak category performance helps active management.

I will restate the matter more simply. By definition, indexes are 100% devoted to their investment categories. They don’t have cash, and they don’t hold securities from other investment styles. They offer the pure category experience. Thus, when an investment category leads the performance charts, the index funds typically outdo their more-diluted actively managed rivals. And vice versa.

Active managers appear to be more skilled when their investment universe performs relatively poorly, and less skilled in the reverse case. But in reality manager skill is stable; it is the measurement that wavers. Because manager-versus-index results are linked to relative-performance results, the time period selected will largely determine the outcome.

Timing is Everything

In other words, active management can be said to be a sound choice for almost any fund category, and it can also be said to be a poor choice. The answer depends on the time period. And if multiple time periods are chosen, the numbers tend to blend together, so there is little room for any conclusion whatsoever. In all fund categories, active managers sometimes perform better than the indexes. More often, because of higher expenses, they do not.

There may be something to the argument for indexing large-cap U.S. stocks, because that arena is the world’s most heavily researched and thus the most efficient. Also, certain fund categories can be difficult to index because they are very specialised or consist of strategies rather than markets.

Source Morningstar. John Rekenthaler | 03/08/2016