Active-versus-passive debate rages on

The stock market’s tumult is breathing new life into the old active-versus-passive debate.

The stock market’s tumult is breathing new life into the old active-versus-passive debate.
The Boston Company Asset Management LLC, which is an active-management investment shop with more than $24 billion in assets, last week released a report making a case for active management following a stock market downturn.
If history is any indication, actively managed funds are poised to outperform their passive brethren, according to the report.
Consider, for example, such difficult market periods as 1974-1975, 1990-1991, and 2001-2002. All those periods were followed by one- to three-year runs during which the majority of active managers outperformed their benchmarks, the report said.
“These periods of market distress have created wide dispersions within stock valuations,” said David Dagilo, senior vice president at The Boston Company, which is one of 19 investment boutiques operating under the umbrella of Boston-based BNY Mellon Asset Management, a unit of Bank of New York Mellon Corp. in New York.
“These wide dispersions can create real opportunities for a manager to sniff out pricing anomalies. It’s a ripe environment for active managers,” Mr. Dagilo said.
Indeed, over the first five months of 2009, 64% of all actively managed stock funds beat their respective benchmarks, the report found.
Of course, it all sounds perfectly logical. Amid market turmoil, valuation spreads reach extremes — thereby presenting opportunities for smart stock pickers.
The problem with that logic, however, is that it is based on the premise of benchmarking active managers against static indexes. Such benchmark comparisons are often flawed, said Russel Kinnel, director of mutual fund research at Morningstar Inc. in Chicago.
“A lot of the active-versus-passive debate is really growth-versus-value and large-cap-versus-small-cap stocks,” Mr. Kinnel said. “Whenever I hear how many active funds beat the S&P 500, I have to remind people that 93% of active funds have market caps that are smaller than the S&P.”
In 2007, Mr. Kinnel took the active-versus-passive debate a step further by creating indexes that reflect the holdings of the active funds in each category.
The average large-cap growth fund, for example, has the following allocation: 49% large growth, 27% large blend, 10% mid-growth, 6% large value, 4% mid-blend, 1% mid-value, and less than 1% each in small value, small blend and small growth.
Mr. Kinnel’s customized benchmark generated a five-year annualized return of 3.9% through 2006. Just 35% of all active large growth funds beat that average.
By contrast, the more traditional practice of comparing the same funds over the same time period to an actual large-cap growth index results in a drop in benchmark performance to an annualized loss of 0.9%; that was beaten by 97% of active managers.
When the customized index methodology was applied across all nine of Morningstar’s style boxes, between 35% and 47% of active managers beat their benchmarks over the five-year period through 2006.
“I’m skeptical about any argument that this, or any other time, is a particularly good time for active management,” Mr. Kinnel said. “The reality is, it’s always the same and, on average, year in and year out, about a third of active managers beat their benchmarks.”
Of course, this does not mean the debate is over and that index funds should be the automatic choice over active strategies.
Remember, there are always managers beating the index, but the key is to identify those managers based on research into criteria such as experience and individual track records.
“That [deeper level of research on managers] will make it much more of a fair fight,” Mr. Kinnel said. “But it still comes down to how good you are at picking out that one-third of active managers that can outperform the index.”