If a portfolio does not maintain a constant level of tracking error (on average), the portfolio effectively becomes either more active or passive through time. If the portfolio is becoming less “active” and charging the same fee, it becomes increasingly unlikely that the portfolio manager will outperform his or her benchmark. This is because, in the absence of any active management skill (which should cancel out in the aggregate, regardless), the active manager should be expected to underperform the appropriately selected benchmark by the total fees of the portfolio.3 Therefore, in order to outperform the benchmark, the portfolio manager will need to take on active risk, thereby deviating from the benchmark.
If individual securities are, in the aggregate, exhibiting less idiosyncratic risk and the portfolio manager does not change the risk profile through some other means, the probability of having a return more similar to the benchmark increases. This in turn increases the probability the portfolio manager will underperform the benchmark by the total amount of fees.
In order to determine whether or not active managers are becoming more or less “active,” an analysis was performed. For the analysis, all data were obtained from Morningstar Direct. The mutual funds included in the analysis are those categorized by Morningstar as domestic equity mutual funds from January 1991 to December 2011. Funds are included regardless of when they exit or leave the test set, and since the available test population is updated monthly, survivorship bias is not a concern.
In order to be included, the mutual fund must be in one of the nine domestic equity style boxes. Also, to ensure fund “purity,” only those funds with the same Morningstar Category and Style Index are included for a given test period. The oldest share class for each fund is used, and any fund classified as an enhanced index, index fund, or fund of funds is excluded from the analysis. These screens limited the number of funds to 2,059 over the entire test period.
Each fund is compared with its respective Russell Index, across value, blend and growth, using the Russell 1000, Russell Mid Cap and Russell 2000 for large cap, midcap and small cap, respectively. The analysis is conducted on a rolling monthly basis and the available test set is determined for that respective historical rolling period. The analysis uses a 12-month rolling historical period for all calculations. All returns are gross returns; i.e., they do not include the impact of investment management fees. The purpose of the analysis is not to opine on the great active versus passive debate, but rather to determine how the nature of active management has changed over time. Note, however, that since expense ratios are relatively constant, they would have little effect on the statistics calculated for this paper (primarily correlation and standard deviation).
While the average correlations are determined at the individual Morningstar category level, the category results are aggregated into a single value for each rolling test period based on the weighted average number of funds available for the given test period by category. This approach overweights styles that typically receive more assets (e.g., large cap versus small cap). However, although only the aggregate results are presented, the overall results are virtually identical across the individual categories.
Past research by Sharpe  noted that style and size explain approximately 80 to 90 percent of mutual fund returns, while stock selection explains only 10 to 20 percent. The results of this analysis confirm these general findings, with the average correlation of the respective fund to its Russell index based on its category being 0.93 (and the average correlation 0.94). That translates into a coefficient of determination (R²) of 86 percent, which is right in the middle of Sharpe’s original estimate. However, the correlation has not been constant through time, as exhibited in Figure 1, which includes the average rolling annual correlation to the respective category index.