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Don't Try to Time Active and Passive Equity Exposure (Part 2)

It’s not advisable to attempt to time exposure between index and active managers.

In the first part of this article, we set the scene by explaining how to measure success of active managers. In this part of the article, we will be looking at our findings.

Success Rates versus Asset-Weighted Return Differences

Despite the differences between these two measures of success, the predictions from Dunn’s Law using asset-weighted return differences compared with success rate largely line up. As a refresher, we built a regression model to explain the variation in active managers’ success rates within each category over time. For the nine U.S. equity categories, the explanatory variables in the model included the returns to market risk, small size, value, and international stocks relative to U.S. stocks. We calculated each of these explanatory variables (or factors) using an index return spread.

The regression analysis measures how closely the variation in active managers’ success rates is linked to the payoff of potential style differences between active and index managers. For example, if active managers in the large-value Morningstar Category have greater exposure to mid-cap value stocks than their index peers, their success rates should improve when smaller stocks beat larger stocks. The regression would detect that relationship.

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About Author

Adam McCullough, CFA  Adam McCullough, CFA, is an Analyst on Morningstar’s Manager Research Team, covering passive strategies.

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