Active vs. Passive Asset Management: Investigation of the Asset Class and Manager Selection Decisions
The goals of this research paper are several: first, to measure the statistical significance of every percentile in the cross-sectional (i.e., across a given Morningstar category) distribution of alphas; second, to use the statistical significance percentile data to designate particular Morningstar categories as candidates for either active or passive management; and third, to conduct predictive analysis along several dimensions to formulate an a priori decision rule for selecting funds with the highest probability of future outperformance.
Overall, in terms of equity asset classes, the results tend to support the traditional active/passive portfolio construction framework, in which domestic large-cap equity is passively managed and active managers are selected for satellite asset classes, particularly domestic and foreign small-cap growth. As for fixed income, the data suggest that municipal bond and short-term government allocations should be passively managed. When analyzing different market environments, contrary to what occurred in the midst of the financial crisis in 2008, active managers generally produce higher alphas during bear market periods than in bull periods. Finally, the data show positive out-of-sample results for portfolios constructed based on certain dimensions, such as low expense ratio or high active return for the previous month.
2. Summary of Results
2.1. Active/Passive Classification of Managers. We carry out the test of statistical significance (positive and negative) for each percentile of the cross-sectional alpha distribution for all (dead and alive) mutual funds in Morningstar database (see Table 1) from January 1980 to May 2013. One minus the lowest statistically significant positive percentile is defined to be the “manager success rate”, and the highest statistically negative percentile is called the “manager failure rate”. We classify a category as active if the lowest statistically significant positive percentile was at the 66th percentile or below. In other words, manager success rate is at least 1/3, which means that at least 1/3 of a distribution of CAPM alphas in a given category are statistically positive. We classify a category as passive if the “manager failure rate” is at least 2/3. In other words, the highest statistically negative percentile for a passive category is at the 67th percentile or above, which means that at least 2/3 of a distribution of CAPM alphas in a given category are statistically negative. A category is denoted as neutral if it is neither active nor passive. The managers with an alpha above or equal to a statistically significant positive percentile are denoted as skilled, while those with an alpha below or equal to a statistically significant negative percentile are denoted as unskilled. Thus, each Morningstar category is divided into a group of skilled, unskilled, and indeterminate managers.
The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this document is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investors specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results.
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