Back in early July, we posted a pair of items on the problem of asset bloat and index-hugging in big, diversified mutual funds (click here and here to see those posts). Writing at Morningstar.com, Marta Norton sees things clearly:
The point of active management is to find a fund manager whose strategy and/or stock-picking abilities will lead to long-term outperformance or at least make for a smoother ride than one could get by buying a cheap, well-diversified index fund. Unfortunately, actively managed funds that are tied too closely to their benchmarks can find outperformance and muted volatility harder to come by.
Exactly right. And there's more:
A benchmark-centric approach is all the more frustrating when it keeps the fund from making the most of its resources. Take Alliance Bernstein Value (ABVAX). The fund has seasoned management and a deep bench of analysts, but it is still benchmark constrained. It won't bet heavily against the largest stocks in its benchmark, the Russell 1000 Value. That means the fund can end up diluting its high-conviction ideas with stocks it owns merely because they're in the benchmark. Not surprisingly, the fund's three-year R-squared clocks in at 98%, meaning that 98% of its returns can be explained by the movements of the Russell 1000 Value. It's lagged the lower-priced iShares Russell 1000 Value Index (IWD) in most rolling one-year periods since its 2001 inception.
We'll keep pounding the table on these issues as new evidence bolsters an already-strong case. And we don't mind repeating what we wrote back in July, which summarizes our thinking on the distinct and complementary functions of active and passive management in a larger investment program:
Now...we aren't suggesting that active management is always and forever doomed to underperform. In any given year, of course, some actively managed funds will outperform their benchmark averages by definition. But over longer periods, big, diversified funds will tend to underperform their benchmarks by an amount roughly equal to their (explicit and implicit) costs and tax-inefficiency.
Active management certainly has a role to play in many investors' portfolios. But we think it should be pursued in the right framework: agile (as opposed to bloated), eclectic (as opposed to style-constrained), and a little contrarian (as opposed to purely momentum-chasing). Risk-averse investors might also look for managers who run money with an absolute-return orientation, where capital preservation matters more than performance relative to some benchmark.
Marta Norton, "Some Funds Stay Too Close to Home: Hewing close to an index can limit risk, but it can also lead to mediocrity," Morningstar.com, August 23, 2007