The ‘Mirage’ of Relative Performance

Relative performance results offer little insight into manager skill, writes Morningstar’s research VP.

In the never-ending debate of active versus passive, historical performance comparisons offer little more than a “mirage,” according to Morningstar’s John Rekenthaler.

In his latest blog post, the columnist and vice president of research argued that relative performance results are heavily dependent on the time period examined, and are therefore a flawed measure for determining active manager skill.

“Active managers appear to be more skilled when their investment universe performs relatively poorly, and less skilled in the reverse case,” he wrote. “That appearance deceives.”

Manager skill is “stable,” Rekenthaler stated. It is the measurement of that skill—relative performance—that wavers. For example, if an overall investment category, such as small-cap US stocks, was the top performer over a time period, a passive fund wholly dedicated to that category will also outperform. An actively managed fund would by definition not hold as much exposure to that leading sector as an index fund, and would therefore perform worse in comparison.

Alternatively, if small-cap stocks tanked, so would small-cap indexes—making actively managed funds look much better than their passive counterparts.

“When an investment category leads the performance charts, the index funds typically outdo their more-diluted actively managed rivals,” Rekenthaler explained. “And vice versa.”

In general, the columnist argued historical performance offered “scant counsel” on the better choice between active and passive—except in the case of a few outliers.

Rekenthaler admitted there “may be something” to arguments that indexing is always best in highly efficient markets—like US large-cap stocks—and active management is necessary in sectors that are more specialized or consist of strategy rather than marketplaces—like target-date funds. Overall, however, he said there is “little room for any conclusion whatsoever.”

“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,” he concluded. “The answer depends on the time period.”

Related: Why Swensen, Buffett Preach Passive—But Bank on Active