The Myth of Core and Explore Part II: Dunn's Law
Myths are often created because there appears to be either some data supporting the idea. This is the case with the core-and-explore approach, which we explored yesterday. Here's another way to look at the folly of mixing index funds and active funds in a portfolio.
Dunn's Law explains why sometimes it appears that active managers outperform in some asset classes. It states that when an asset class does well, index funds will outperform active managers in that asset class. However, when an asset class does poorly, active managers have a greater chance to outperform their benchmark index. This is why, on occasion, you will see S&P's Indices Versus Active Funds Scorecard (which covers nine asset classes) showing a majority of active managers outperforming during a particular period in one or two asset classes.
The explanation is that index funds -- because they have "asset class purity" -- generally achieve the greatest exposure to the relevant risk factor responsible for the vast majority of the returns. Active managers tend to style drift (as large-cap funds often own mid-and small-cap stocks and small-cap funds often own mid-and large-caps). Thus, active managers lose some of their exposure to both the "winning" and "losing" asset classes.
The result is that when large-cap stocks outperform, large-cap indices trounce active managers. However, you may find that active small-cap managers beat their benchmark indices during such periods. Again, the reason is style drift:
- Large-cap active managers may own small-cap stocks, dragging down the fund's performance.
- Small-cap active managers may own large-cap stocks, giving the fund the opposite effect.
Asset Class | Return (%) | Percentage of Actively Managed Funds Outperformed by Their Benchmark Index |
Large-Cap Growth (Russell 1000 Growth) |
-24.5 |
76.7 |
Small-Cap Growth (Russell 2000 Growth) |
-24.9 |
60.7 |
Small-Cap (Russell 2000) |
-25.0 |
53.7 |
Small-Cap Value (Russell 2000 Value) |
-25.3 |
53.9 |
Large-Cap (Russell 1000) |
-26.7 |
51.0 |
Large-Cap Value (Russell 1000 Value) |
-29.0 |
29.7 |
Dunn's Law provides us with the winning strategy. If you can forecast the top performing asset classes, the best chance of capturing those returns is by purchasing an index fund. You would avoid the asset classes that perform poorly -- where active managers have a better chance of outperformance. If you can't make such a forecast, you should choose index funds anyway, because that's the only way you can control your asset allocation, the major determinant of returns and risk.