Passive Wins With Risk Adjusted Returns
October 18, 2009 by Tisa Silver
Filed under Finance
A recent study completed by Morningstar showed that active management loses to passive management on a risk-adjusted basis.
No surprise there. Many funds or managers may boast of high returns versus the market, but they forget to recognize one huge factor: RISK!
Photo by stopnlook, courtesy of flickr
Let me explain. If an active manager is able to provide a return of 30 percent versus the market rate of 15 percent, then on the basis of raw returns, the manager has beat the market.
But, if the returns were achieved by the manager taking five times the amount of risk that the market bears, then the manager has not beat the market.
Beating the market occurs when an active manager is able to offer a rate of return higher than the market while assuming the same amount (or a lower amount) of risk.
Enter the Morningstar study. The research showed that approximately half of actively managed funds outperformed their indexes. However, only 37 percent of the funds still outperformed the indexes on a “risk-, size- and style-adjusted basis.”
So before investing in any fund, evaluate the fund’s returns with risk in mind. If a fund assumes a high amount of risk and offers a high rate of return, it’s not beating the market, it’s doing what it is supposed to do.
For what period of time is the Morningstar study? The longer the time interval, the larger the number of funds that revert to the mean, and fewer funds end up outperforming the market. Also, do the results factor the taxes paid on capital gains distributions?
Hi Jim, The Morningstar study focused on 3 year returns and the results were similar (as in passive outperformed active) for 5 and 10 year holding periods just like you said. The study looked at raw returns first, and only adjusted thereafter for style and size. The gap would be greater with taxes considered.