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olling annual correlation to the respective category index.
Since 1991, the average correlation for actively managed
mutual funds has been increasing. As of December
2011, it was at its approximate highest level in history,
with the average fund having a correlation of 0.982 to its
respective category index. Viewed differently, a correlation
of 0.982 means that 98.2 percent of the return of a
given active manager can be described entirely by the
underlying benchmark index. This suggests the active
manager is only adding roughly one-thirtieth of the total
deviation in returns, but in many cases charging 10 times
or more than what a comparable passive strategy costs.
Note that the t-statistic associated with slope is 11.73, suggesting
an incredibly high level of statistical significance.
Another way to view the changing “active” exposure
of mutual funds through time is the standard deviation
of the correlations. This metric captures the dispersion
of all active managers through time. It is possible that
while the average is increasing, there could also be a
greater level of dispersion among portfolio managers.
Unfortunately, as demonstrated in Figure 2, the average
rolling category correlation standard deviations
have also been decreasing. This suggests that, on average,
an increasing number of actively managed mutual
funds are clustering more and more tightly around their
respective category benchmarks. The t-statistic associated
with slope is -8.84, suggesting an incredibly high
level of statistical significance.
The final test to determine the direction of the “active”
portion of actively managed mutual funds is based on the
average tracking error of the fund versus its respective category
index (Figure 3). For this test, other than two noticeable
spikes, the clear trend has been a decreasing level
of tracking error through time. Again, this suggests active
managers are in fact less “active” than they used to be. The
t-statistic associated with slope is -3.13, suggesting a relatively
high level of statistical significance.
Conclusion
It is impossible to pinpoint an exact reason why actively
managed mutual funds are becoming less “active,” but
the evidence would certainly suggest this is the case. One
theory this author believes could be a driving force behind
Figure 3
Average Tracking Error
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
Average Rolling Average Category Tracking Error
Dec-91 May-97 Nov-02 May-08
Source: Morningstar
One Year Period Ending
y = 6E-0.7x + 0.0394
R 2 = 0.0409
this change is increased movement to index investing. As
more investors “index” their portfolios, more and more
trading volume is based not on some technical analysis
about the future earnings of a given company (for example),
but instead whether or not a given security is included
in a particular index (the S&P 500 in particular) and to
what extent. Alternatively, it could be that “style purity” is
becoming increasingly important for benchmarking purposes.
Regardless of the reason, active funds have clearly
become less active through time.
These findings present an interesting environment
for active management. First, as more money flows to
index funds, less money must be flowing to active strategies.
Although active as well as passive investments can
be “winners” from a positive flows perspective, the relative
gain of either category definitely comes at the cost
of the other. Second, if higher levels of flows into passive
funds do create an environment that makes it more difficult
for active management to outperform, and if an
increasing amount of flows go to passive/index strategies,
the ability of an active manager to outperform is
likely to become increasingly hampered. Finally, for an
efficient market to exist, there must be some active management.
It is beyond the scope of this article to venture
a guess as to where this point is, but we don’t appear to
be there yet. It will certainly be interesting to see what
happens if we do ever get there.
References
Investment Company Fact Book. 2011. http://www.ici.org/pdf/2011_factbook.pdf
Sharpe, William. 1992. “Asset Allocation: Management Style and Performance Measurement.” Journal of Portfolio Management, vol. 18 No. 2: 7-19
Sias, R.W., L. Starks and S. Titman. 2006. “Changes in Institutional Ownership and Stock Returns: Assessment and Methodology.” Journal of Business, vol. 79 No. 6:2869-2910.
doi:10.1086/508002
Sullivan, R. and Xiong, J. X. 2012. “How Index Trading Increases Market Vulnerability.” Financial Analysts Journal. Forthcoming, available at SSRN: http://ssrn.
com/abstract=1908227
Endnotes
1
Sullivan and Xiong [2012]
2
Sias, Starks and Titman [2006]; Sullivan and Xiong [2012]
3
Both explicit management fees and implicit fees that result from trading, such as the bid/ask spread and commissions
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