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By Ben Johnson, CFA and Christine Benz | 04-21-2016 02:00 PM

Are Index Funds Still Winning?

Morningstar's Ben Johnson discusses the latest performance findings from Morningstar's Active/Passive Barometer report.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. How do active and passive funds stack up? Joining me to discuss some recent research on that topic is Ben Johnson. He is director of global ETF research for Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Glad to be here, Christine.

Benz: Twice a year you put out what is called the Active/Passive Barometer. You have just concluded some data with an endpoint of the end of 2015 where you compare not just the performance but also the longevity of active funds relative to passive products. Let's talk about how you crunch the numbers there. What specific factors are you looking at?

Johnson: Our study is unique with respect to the way we benchmark active managers. Our benchmark in this case is actually a composite of the performance of all of the index mutual funds and exchange-traded funds in a given Morningstar Category. If, for example, we're looking at success rates amongst U.S. large-cap blend equity managers, we are including SPY, the SPDR S&P 500 fund, in that composite benchmark. We're including the Vanguard Total Stock Market Index fund in that composite benchmark.

This is important in that it gives us a more real sense of the actual outcomes that are being experienced by investors in active funds versus investors in passively managed funds. Many studies that look at exactly this same question tend to use an index, a single index, as the benchmark. The drawback there is that indices in and of themselves aren't directly investable. So, by using an index you're not able to capture all of the messy realities of trying to build a portfolio to track that index; fees, transaction costs, taxes in certain cases.

The other issue with that is that you can cherry-pick an index, and not all indexes are created equal. So our composite--our index is an amalgamation of all of the different indexes underlying all of these funds, all of these ETFs. The net result is a more real comparison of how active managers are faring on average relative to their index fund and ETF counterparts.

Benz: So are you asset-weighting at all? So, are you giving a greater weight to the bigger index funds and less of a weight to some of the small fry?

Johnson: So, we look at this through two separate lenses, two separate weighting schema. In calculating success rates we look at this on an equal-weighted basis. In calculating performance figures we look at both equal-weighted as well as asset-weighted performance across both actively managed funds and passively managed funds. What we found in both cases is that passively managed funds have on average, across virtually all categories, tended to outperform actively managed funds.

That said, what we've also seen is that the asset-weighted performance of active strategies across all categories has been greater than the equal-weighted performance. Now, what you can read into that is that investors choosing active funds have tended to on average select above-average active funds.

Benz: So, you mentioned success rate. I'd like to talk about what that is. What you're trying to capture there with that particular statistic?

Johnson: The way we define success rate for an active fund to be successful it has to have first survived the entire time period in question. We look back at the trailing one-, three-, five-, and 10-year periods and first and foremost, look to see which funds that existed at the beginning of that period, lived to see the end of that period.

The second hurdle for success is to have produced a return that was in excess of the return of that composite benchmark, again that amalgamation of the returns of all of the index funds and ETFs within these funds' respective Morningstar Categories. For example, if I was an active manager in the U.S. large-blend category and I survived the 10-year period that ended at the end of 2015, and I produced a return that was greater than that mashup of SPY and Vanguard Total Stock Market Index Fund, we would count that manager as having been successful.

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