Back to Frontier Insights
Frontier Insights

Monthly Perspective | March 2019

30 October 2019

Geremy van Arkel, CFA® | Principal

We Use Both

In general, I loathe the topic of active versus passive management as it pertains to mutual fund or ETF selection. The debate over active and passive is one of those binary all-or-nothing argument starters. Like questions such as bull or bear, tactical or strategic, benchmark or drift, conservative or liberal, the answer is usually grey: both, neither, or sometimes. This is because the question itself belittles the complex fabric of the subject, and what it means to be an independent thinker. I might also dislike this topic because I think the argument is not an organic one, but instead, one that has been created and perpetuated by purveyors of index products. Isn’t it the default mode for investment managers to add value? It seems unnatural to simply give up and index. Or, maybe it is far simpler. I have chimed in on this subject too many times over the past 25 years. Hence, as this may be the last time that I write about this topic, this time I’ll do it with a little more force.

To me, the options in the “debate” of active versus passive are not all or nothing; one or the other. The answer is: both.

There is such a thing as an active manager who cares about delivering added value through security selection. Those managers really do exist. And, just like with any other endeavor on earth, some of these managers are better than others. At the same time, there is a plethora of mutual funds and ETFs that provide exposure to certain indexes and investment styles in a static, cheap, and efficient manner.

Our role at Frontier is to guide our clients through the unknown future, and to provide efficient growth and consistent added value while not exposing the clients to too much risk, and to do all of this at a reasonable cost. Most of the time we invest both in actively managed mutual funds and passive index funds; we are agnostic as to which to choose at any point in time. We do this because we recognize that added value at the security selection level exists, and it is our job to do everything that we can to provide our investors with a better return experience. Our clients’ assets, their lives, their safety, and their growth deserve our best effort in this area.

While that is a philosophical answer, many want hard data. They need clear lines: 100%, black or white, one or the other. Like with any other “debate”, this, too gets messier, the deeper you dig. I will try to keep it simple.

Let’s start with the fat pitch. Indexers proclaim that “the average active manager underperforms indexes.” This is a powerful sound bite – it sticks with you, is impactful, and goes straight to the heart of that certain percentage of the population that are pre-programmed to doubt everything. However powerful this statement may be, it is irrelevant. It certainly does not say “every active manager underperforms indexes.”

A word to clarify the difference between “average” and “every.” There are about 1,000 U.S. large cap mutual funds that we quantitatively review each quarter. If I were to average the 5-year returns of all these funds into one giant average number, that average would trail the 5-year return of the S&P 500® index. There is no great insight in this statement. It is simply the law of large numbers at work. However, if I were to line up all 1,000 funds, from highest 5-year performance to lowest, it would be clear that hundreds of funds may have outperformed the S&P 500® index. This is a completely different point of view.

Let’s say that on average, over any given year, about 30% of large cap funds outperform the
S&P 500® index. That leaves 300 funds to choose from. With a little more work, one might even uncover the funds that we have utilized in this space over the last five years.

So, You are Telling Me There is a Chance – Frontier Large Cap Holdings:

5 Year Avg. Ann. Return

Ending 1/31/2019

Fund S&P 500® Index
Akre Focus I 13.58% 10.96%
Alger Spectra Z 12.09% 10.96%
PRIMECAP Odyssey Growth 12.56% 10.96%
Sterling Equity Income I 9.33% 10.96%
Vanguard Index Inv. Class 10.80% 10.96%
Source: Morningstar

The second argument in favor of indexes is that index products are low-cost, some you can invest in for free. Now, that is a good point – no argument here. More to that, though: indexes in and of themselves do not have expenses, but products that replicate index performance do. And, lest we forget, all mutual fund and ETF performance is after these expenses. Thus, I have included the Vanguard Index Investor Class fund to allow for more of an apples-to-apples comparison.

I must admit that the reason I am so re-energized to this subject is Morningstar’s Active/Passive Barometer Study (February 2019). First off, I commend Morningstar for their thoughtfulness and thoroughness of the study. It might just be the most complete study that I have seen on the topic. Secondly, while it seems like the subtext of the study seems to want to highlight how much better indexing is than active management, it doesn’t actually universally succeed at that.

I confess to having had a “wait… whoa… what?” moment when reviewing the results.

Percentage of actively managed mutual funds outperforming index funds, and their 10-year dollar-weighted excess return.

Source: Morningstar’s Active/Passive Barometer Study (February 2019), Exhibit 3, Trends in Active Funds’ 1-Year Success Rates by Category (%), Source: Morningstar. Data and Calculations 12/31/2018.

The table above, displays results of the study, by asset class, the percentage of actively managed mutual funds that outperformed similar live index funds in the same category. For visual effect, I color-coded the results as follows; red < 30% of active funds outperformed index funds, yellow, between 30-50%, green > 50% of active funds in that year outperformed index funds.

The last column included shows the dollar-weighted excess returns of investors by how much investors who selected actively managed funds outperform their index fund counterparts – in other words, did investors do a good job selecting actively managed funds or index funds.

So here is my “wait… whoa… what?” moment:

  • On average, investors who selected actively managed mutual funds for U.S. stock categories had a difficult time. No surprise here.
  • Across the entire table, the average percentage of actively managed funds outperforming index funds is 41%. That is higher than I would have thought.
  • Investors selecting actively managed mutual funds for international and fixed income exposures experienced significant outperformance relative to index funds. 
  • The dollar-weighted excess returns occurred over the 10-year period ending 2018, which represents a solid bull market when indexes are expected to outperform.

According to this extensive Morningstar study, it seems quite apparent to me that even the most average of investors should not have indexed international or fixed income exposures. However, what is even more surprising is the industry-wide adoption of 100% indexing strategies.

Given this outstanding performance of actively managed international and fixed income mutual funds, why is it that asset managers are choosing to index their entire portfolios?

I propose four reasons:

  • Most have failed in the past to capture added value through mutual fund selection – added value after the fact is hard.
  • It is easy to index.
  • The indexes are proprietary to the strategist. In effect, the allocation strategy is simply a delivery mechanism to sell more of their own index funds.
  • Indexers are trying to mitigate responsibility. By simply providing market exposures, strategists can say: it wasn’t my fault, it was the markets.

All this being said, none of this really has much to do with how Frontier manages money, other than, we are independent thinkers and can choose to use both actively managed and index mutual funds. As I mentioned earlier, the above line of reasoning belittles a complex subject, boils it down to a soundbite.

The real problem with implementing strategies with actively managed mutual funds is not a question of “on average” outperformance. The question is this: can strategists consistently identify actively managed mutual funds that outperform in the future? Second to that question: can strategists consistently combine actively managed mutual funds into portfolios that represent specific return and risk characteristics as well as provide consistent outperformance after the fact? This is where the data exits theory and enters reality. The fact of the matter is that achieving portfolio outperformance consistently is really hard.

Of course, significant added value at the security selection level exists, but there are several reasons why this elusive added value is so difficult to capture. These include:

  • Style boxes don’t reflect the true strategies of many active managers.
  • Many of the very best managers don’t care about or adhere to style boxes.
  • Performance is measured over specific periods, which may or may not repeat.
  • Performance relative to single indexes is not predictive.
  • No one “knows” which single manager is going to outperform beforehand.
  • Active managers need to be actively managed, “set it and forget it” sooner or later fails.
  • Combining active managers for specific return for risk outcomes requires consideration of how active managers work together.

In short, the real problem is the style box building block methodology. Comparing actively managed funds to single style box indexes, over specific time periods like the past 5 years, is not a predictive measure of whether a fund is likely to outperform in the future. Secondly, the combining of active managers representing respective style boxes into a strategy, may or may not reflect the desired asset allocation or return for risk outcome.

These issues are not a Frontier problem. First off, Frontier does not use style boxes in our mutual fund evaluation and selection process. We have developed our own time-tested methodology we believe is far more predictive at identifying managers who are likely to outperform in the future. Secondly, Frontier does not “pick” managers based on slices in an asset allocation pie chart. We have developed an optimization process testing millions of combinations of funds. This helps us answer the question of which single combination of funds best provides the desired return for risk characteristics. We use this to provide consistent added value through multiple market environments. Finally, we run our process every month, where we can adjust our inputs, and continuously work to improve the process.

And, none of this is in theory. We have a 20-year track record clearly showing our ability to capture added value at the mutual fund selection level. While many rely on the pie chart to save them, I propose that there is no such thing as the perfect pie chart. Furthermore, added value at the allocation level can either result in better risk management or higher return. However, achieving excess returns at the allocation level is unreliable. Not many have actually been able to do this, and certainly not consistently. Added value at the security selection level – from actively managed mutual funds – is all you have left. And, if done right, can be your most consistent excess return tailwind.

On that note, I will leave you with this quote from a wise advisor;

“If we are being honest here, it was your active decision to put me in this passive strategy.”

  • John Bodnar – Bodnar Financial, Florham Park, NJ

Past performance is no guarantee of future returns.  Performance discussed represents total returns that include income, realized and unrealized gains and losses. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types of securities and no investment decision should be made based solely on information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for an investor’s financial situation or risk tolerance. Diversification and asset allocation do not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before investing, consider investment objectives, risks, fees and expenses. All calculations of performance are by Frontier.
Information provided herein reflects Frontier’s views as of the date of this newsletter and can change at any time without notice.  Frontier obtained some of the information provided herein from third party sources believed to be reliable, but it is not guaranteed, and Frontier does not warrant or guarantee the accuracy or completeness of such information. The use of such sources does not constitute an endorsement. Data sources for funds and indices are Morningstar, the Hedge Fund Research Institute and BarclayHedge. Other sources include: National Geographic.
Exclusive reliance on the information herein is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance.  References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell any securities, commodities, treasuries or financial instruments of any kind.  This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal, investment or tax advice.
Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision.
Hypothetical expected returns have certain limitations, are shown for illustrative purposes only and it should not be assumed that actual results will match the hypothetical expected returns shown. Unlike actual performance, hypothetical expected returns do not represent actual trading and since trades have not been executed, the results shown may have under or over compensated for the impact, if any, of certain unforeseen market factors. Hypothetical expected returns, whether back-tested or forecasted, have many inherent limitations and no representation is being made that any account will or is likely to achieve the results shown. In fact, there are frequently material differences between hypothetical expected results and actual results achieved. One of the limitations of hypothetical expected results is that they do not take into account that material market factors may have impacted the adviser’s decision making process if the firm were actually trading clients’ accounts.  Also, when calculating the hypothetical expected returns, the adviser has the ability to change certain assumptions and criteria in order to reflect better returns. There are numerous other factors related to the markets in general or to the implementation of any specific investment strategy that cannot be fully accounted for in the preparation of hypothetical expected results, all of which can adversely affect actual trading and performance. Importantly, it should not be assumed that investors who actually invest in this strategy will have positive returns, or returns that equal either the hypothetical expected results reflected or any corresponding benchmark presented.  In addition, performance can, and does, vary between individuals.
In reviewing the performance information presented here, we recommend that you consider both the returns generated and the level of risk that was assumed in generating those results. We believe that performance information cannot be properly assessed without understanding the amount of risk that was taken in delivering that performance. The performance information presented here covers different time periods. We present performance information for short time periods because we understand that clients and potential Investors are interested in this information, however, we recommend against making any investment decisions based on short-term performance information. For any investment products mentioned herein, a complete description of their investment objectives, along with details of the risks and fees involved is contained in their respective prospectus and statement of additional information, which is available on their websites and should be read fully.
It is generally not possible to invest directly in an index*. Exposure to an asset class or trading strategy or other category represented by an index is only available through third party investable instruments (if any) based on that index.
S&P 500®
Represents US large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ
HFRX Global*
Represents the hedge fund universe. It is comprised of all eligible hedge fund strategies; including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage, and relative value arbitrage.  The index is weighted based on the distribution of assets in the global hedge fund industry. It is a trade-able index of actual hedge funds.
HFRX Absolute Return
The HFRX Absolute Return Index is designed to be representative of the overall composition of the hedge fund universe. It is comprised of all eligible hedge fund strategies; including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage, and relative value arbitrage.
Russell 2000
Measures the performance of the small-cap segment of the U.S. equity universe
Measures international equity performance. It is comprised of the MSCI country indexes capturing large and mid-cap equities across developed markets in Europe, Australasia and the Far East, excluding the U.S. and Canada.
EAFE Small
Measures small cap equities across Developed Markets countries around the world, excluding the US and Canada.
MSCI Emerging Markets
Measures large and mid-cap equities across 23 Emerging Markets (EM) countries which include Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Russia, Qatar, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.
This is a free-float adjusted, market capitalization-weighted index of U.S. Equity REITs. Constituents of the Index include all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property.
Bloomberg Commodity Index
This is a broadly diversified index that allows investors to track commodity futures through a single, simple measure. The DJ-UBSCISM is composed of futures contracts on physical commodities.
Barclays Capital Long U.S. Treasury
Includes all publicly issued, U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value
Benchmark Composition. The Benchmarks for the Long-Term Growth, Growth & Income, Balanced, Conservative and Capital Preservation strategies are combinations of the Wilshire 5000 Total Market Index, MSCI All Country World ex US Index, Bloomberg Commodity Index, HFRX Global HF Index, Barclays US Aggregate Bond Index and 3-Month T-Bills.
The blends of the indices are currently:
Capital Preservation Bench
Conservative Bench
Balanced Bench
Growth & Income Bench
Long-Term Growth Bench
Wilshire 5000
MSCI AC World ex US
Bloomberg Commodity
HFRX Global HF
Barclays US Agg
3M T-Bills
Benchmarks for the Global Opportunities, Focused Opportunities, Absolute Return Plus, Absolute Return and Short-Term Reserve strategies are the MSCI World, S&P500®, HFRX Global HF, HFRX Absolute Return and Barclays Capital 1-5 Year US Treasury Indices, respectively. In the case of indices that include foreign securities, index returns are still presented on a total return basis but will be net of foreign taxes on income generated by these securities.
Frontier’s ADV Brochure is available at no charge by request at or 307.673.5675.

Frontier Insights

Geremy’s Thoughts