A recent research paper by RidgeWorth Investing, “Large Cap Value Indexing Myth-Conceptions”, seeks to demonstrate that large cap value managers can add value over the Russell 1000® Value Index.
The paper endeavors to dispel several “myths” about large cap value passive investing. This post focuses on one of these presumed myths: "The selection process for an active manager is not worth the effort." To make that point, the paper takes a unique approach to comparing active managers against the index.
To establish a basis for comparison with the index, the study made its selection from the Morningstar universe of 310 actively managed large cap value funds with three- and five-year performances over the last 10 years. These parameters reduced the number of funds to 253. The study further winnowed the funds down to those that have a minimum of 10 rolling observations for these periods and those managers who outperformed the index at least three-quarters of the time across all rolling three and five-year periods.
The final group represented 61 funds or 24% of the original Morningstar universe of 310 funds. This group outperformed the index by 5.73% over all rolling three-year periods and 13.74% across all rolling five-year periods. The paper also looks at each fund’s risk adjusted return based on its information ratio, which outperformed the index in three- and five-year rolling observations by 82% and 95%, respectively.
At first blush at least, it would seem that taking this select group and using it as a basis for comparison is to effectively create a stacked deck. In other words, something akin to moving the target after the arrow has already left the bow. However, the major point of the study was how the select group of 61 large cap value funds differed from the funds that were excluded from the comparison. There were three main areas of divergence:
• Manager tenure: The outperformers had 31% longer tenure than the first cut of 253 funds and 42% higher tenure than the entire Morningstar universe of 310 funds.
• Investment style: Less variance as tracked by the Morningstar Style Box™ analysis.
• Fund expenses: Averaging 0.95% for the select group of 61 funds, 1.03% for the 253 evaluated funds and 1.01% for the larger universe of 310 funds.
Conclusion
As is increasingly the case in the DC world, the focus is on total cost. While it is hard to drive down certain fixed costs such as record keeping, investment management fees can be cut dramatically by simply shifting from active to passive investing.
One of the challenges this approach creates is that it questions at least one of the major value-adds of the plan advisor, which is the role of selecting good managers. Hence, the emergence of core/satellite fund lineups, which is a strategy that recommends that asset classes perceived to be efficient (e.g., large cap equities, intermediate bonds) are passively managed while the less efficient fund types (e.g., small cap, emerging markets) are actively managed. The goal: to accomplish the twin objectives of reducing costs while adding value.
Plan advisors who have not adopted the core/satellite approach to building fund menus, and thus are seeking alpha in large cap value, are the advisors who may benefit from an analysis like this, which concludes that in addition to performance and risk-adjusted returns, three important areas to screen are manager tenure, style discipline and fund expenses.
However, an important missing piece is just how much weight to give to each of these five areas. This would appear to call for a broader study that places controls on each of these five variables in order to best determine the statistical correlation between each of these fund attributes and outperformance.
As this study attests, the expedition in search of the Holy Grail of alpha — in even the supposedly most efficient markets — continues. However, the question always remains the same: Is the cost of the journey worth it? The answer will always be elusive given that the efficacy of passive investing is based on active pricing. And when the pendulum swings to either extreme, it is usually the other side that becomes the place an investor wants to be. The NASDAQ 100 index at 4,700 in early 2000, anyone?
