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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.
The mid-year 2009 S&P Indices Versus Active Funds Scorecard provides us with a good example of Dunn's Law at work. The table below shows the results for the one-year period July 2008 through June 2009. I have ranked the asset classes by order of returns.
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

A few points are worth noting. First, despite the bear market, active managers failed to beat their benchmarks in five of the six asset classes. Second, the asset class with the best return had almost 77 percent of active managers fail to beat the benchmark. However, more than 70 percent beat their benchmark in the worst performing asset class. And there is almost perfect symmetry in the data - the better the relative performance, the more active managers failed to beat their benchmarks.

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.