Active vs. Passive Funds: Why Is Style Purity So Important?

by: Lawrence Weinman

Standard and Poor's publishes a comprehensive review of active vs. passive funds. The whole study is here.

The WSJ summarized some of the results:

Investors who rely solely on low-cost index funds in their portfolios are missing advantages that active management can provide in select sectors of the market, some industry professionals argue, bolstered by a recent study on fund returns.

Index funds have increased in popularity because of the lower cost and the fact that the majority of active fund managers can't beat the performance of benchmark indexes. According to a study by S&P, roughly 60% of stock-fund managers lagged behind their index over five years to June 30, and with the exception of emerging-market-debt funds, at least 75% of bond-fund managers lagged behind their index.

But different areas of the market may require different approaches, some said: Where there is less information about companies, such as small-caps or international stocks, or less liquid markets, such as real-estate or emerging-market bonds, active management can provide an edge..

I would note that the S&P data for a 5 yr. period shows foreign small cap funds as performing particularly poorly: 70.6% underperformed the index. Emerging markets, another relatively illiquid category, performed even more poorly with 89% underperforming the index. I wouldn't categorize mid cap growth as a particularly illiquid market. Certainly small cap stocks are more illiquid and once again the fund quest data does not match the 5 yr. S&P data: 75.88 mid cap growth underperformed the index.

There is another reason for choosing index instruments over actively managed funds other than relative performance: style purity. Style purity, to put it in simple terms, is "truth in labeling": whether the fund actually holds most of its stocks in the category in which the fund is labeled. The S&P data show a poor record for actively managed funds in this measure. Domestic equity funds show a "style purity" measure of between 38-64%. In simple terms it means even the highest rated fund holds 36% of its stocks from those outside its category. For bonds the measure is quite high in the 80-90% area. But bond funds do far worse than stock funds in outperforming their index. International funds have a higher score of 75-88% (emerging market).

Why is this so important? Because if an investor is implementing an asset allocation with defined percentages in a range of asset classes, the lack of style purity in active funds makes this near impossible. For example, if one wants to allocate 15% of a portfolio to small cap stocks and chooses a small cap active fund with a 60% style purity, it means using this fund makes one's portfolio only 9% investing in small cap stocks. But it gets worse: the large cap fund could hold some small cap stocks, further complicating things. And it gets even worse: the data on holdings is published each quarter so it is impossible to know the current holdings.

Of course none of these problems occurs with the use of index instruments; the holdings always match the label of the index. A small cap etf or index fund holds 100% small caps.