Morningstar Advisor - December/January 2012 - (Page 65)

Adjust the study so that it compares fund averages for each of the nine Morningstar Style Box categories against their nine style indexes, and the story changes. Now, the funds lag by 118 basis points for three years and 49 basis points for 10 years—not a great difference. Given that survivorship bias boosts the funds over the longer time period, the claim disappears entirely. In this article, I’ll address two common difficulties when analyzing the performance of active versus passive management— benchmark fallacy and benchmark choice. I’ll then suggest a better way of thinking about where indexing might fail. Case Study: Vanguard Intermediate-Term Bond Index Morningstar’s Eric Jacobson, bond portfolio managers have been unwilling to match the index fund’s current portfolio because of “philosophy, instincts, or client pressure.” By philosophy, bond managers don’t feel as tied to indexes as do stock managers. Managers by instinct have shied away from assuming the index’s level of risk as the bond rally has shrunk yields and raised durations, making bond funds more volatile. Finally, clients seek stability and yield from their bond funds, and neither are enhanced by the index fund’s Treasury-heavy strategy. Index-fund wanderings occur more often than one might expect. For various reasons— ranging from the idiosyncratic design of an index to market architecture (that is, one security, one sector, or one country dominating the market) and fund-manager beliefs— an index fund frequently will not serve as a neutral position for its category. This can also occur because of external market preferences—for example, if foreign governments prefer long-dated Treasuries to shorter securities and to government agencies, then they will push up the prices of long Treasuries, thereby nudging the U.S. mutual funds toward the latter assets. The Benchmark Fallacy flipped and argued that it’s easier to add value as an active manager running an international portfolio than a domestic portfolio. They couldn’t have been correct both times—but they could have been incorrect twice. The benchmark fallacy is distressingly common. In the 1980s, it led to flawed arguments that active investment managers were particularly poor at investing internationally, followed in the 1990s by equally flawed arguments that managers had insights internationally but were dopey domestically. Similarly, recent evaluations of the ability of domestic-stock managers have primarily been driven by the relative success of giant-cap stocks, as the S&P 500 tends to own bigger companies than even most large-cap stock managers. This problem extends into other areas besides fund evaluations. For example, in the 1990s, a consultant published a widely cited paper showing that 401(k) plans had dramatically lagged a composite index that was made up of 60% of the S&P 500 Index and 40% of the BarCap Aggregate Bond Index. His interpretation that 401(k) investors were hopelessly incompetent was accepted without reservation by the financial media. This conclusion was at best preliminary, at worst wrong. The consultant’s index was made up of two assets that had recently soared: blue-chip U.S. stocks and high-quality U.S. bonds. Meanwhile, most of the large 401(k) plans that made up the study were diversified per Modern Portfolio Theory and held multiple alternate asset classes—all of which had trailed the two assets that made up the consultant’s composite index. You know the sequel. Over the next 10 years, U.S. blue-chip stocks were awful, so poor that even good performance by high-quality U.S. bonds could barely get the composite index in the black. Meanwhile, Modern Portfolio Theory paid the rent. Foreign blue chips weren’t good either, but small-company, real estate, commodity, and emerging-markets stocks were On Aug. 11, Morningstar’s Christine Benz noticed something quite peculiar—the single-best-performing intermediate-bond fund over the trailing month, out of 1,238 funds in the category, was Vanguard IntermediateTerm Bond Index VBIIX. Not exactly The House That Jack Built. Certainly there are performance variations, and index funds wouldn’t be expected to place in the 45th percentile each and every month. But landing in top thousandth? After one month? What in the name of Bogle had happened? What happened is a frequent problem for judging the attractiveness of passive versus active management: The index fund invests quite differently than do the other funds in the category. Vanguard Intermediate-Term Bond Index has one of the longest durations of any fund in the category (34th on the list) and one of the highest allocations to Treasuries (15th). With bond prices rallying amid a flight to quality, the fund rode the bull. It gained 4.6% for the month, triple the category average and 50 basis points ahead of any nonindex fund. Most intermediate-term bond funds benchmark their performance relative to the Barclays Aggregate Bond Index. However, says This gap between the structure of indexes and the structure of funds leads to major interpretive problems. If an index fund can differ from its peers so dramatically as to be the top fund in a huge category over a 30-day period, then it can also differ from its peers so dramatically as to invalidate active versus passive comparisons. In such instances, conclusions about the effectiveness of indexing a particular asset class are mistaken. Consider what occurred with internationalstock funds when they almost universally trailed the Japan-laden MSCI EAFE index during the 1980s, then reversed and almost universally outperformed that same index the following decade. First, people argued that the managers were incompetent. Then, they MorningstarAdvisor.com 65 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - December/January 2012

Morningstar Advisor - December/January 2012
Contents
Contributors
Letter From the Editor
Seduced by Complexity
Is China Exposure Important for a Portfolio?
A Niche Built on Trust
How to Find Your Client’s Investment Style
Taking the Long View
Consensus on Europe Elusive
Four Picks for the Present
Investment Briefs
Is Perception Reality for Active Managers?
Be Alert for Basic-Materials Bargains
Investment Boom Unsustainable
Digging Moats in China
Where China’s Domestic Companies Stand to Benefit
Arising Opportunities
China Strong Long Term
From Currency Manipulation to International Acceptance
The Keys to China’s Fortune
Wedgewood’s Lessons Pay Off
Reading the Evidence on Indexing
Scouting for Investments Abroad
Yield, Please (Hold the Europe)
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
China Fund Managers Eat Elsewhere

Morningstar Advisor - December/January 2012