Dunn's Law – more fuel for the active/passive fire?

05 April 2019

By John Husselbee, Co-Fund Manager HC Verbatim Portfolio Growth Funds

Despite peace-making attempts by investors pushing the case for a blend of active and passive funds in a diversified portfolio, the so-called Great Debate rumbles on.

Our attitude to this has remained constant and we continue to employ active and passive vehicles in our target-risk portfolios. When investing in an asset class, we identify the availability and suitability of tracker options first and then look at whether it is worth paying up for active managers.

For those yet to be convinced of the merits of holding both however, many investors will be trying to switch between the two at optimum times and one proposed method on which to judge this is known as Dunn’s Law (after Steve Dunn, a friend and cohort of US financial academic William Bernstein).

This attempts to explain why certain periods have been kinder to active managers than others and the ultimate conclusion is that when an asset class does well, an index tracker in that class will usually outperform actively managed funds, but when an asset class does poorly, actively managed funds will beat the index.

To explain this, the concept of asset class purity has emerged: the reason why more active managers beat their benchmark in underperforming styles is because indices are pure plays on a style while active managers often select at least a few securities outside that style.

As indices tend to be more ‘style pure’ than active counterparts, they should be harder to beat when the style they represent has strong relative performance. Conversely, they should be easier to beat when their style has weak relative performance.

This was the topic of a recent research from Morningstar, with the group looking to put Dunn’s Law to the test and establish whether style purity really can be a predictor of performance.

Focusing on quarterly rolling one-, three-, and five-year performance from September 2002 to December 2017, Morningstar found that Dunn's Law has some merit, although the results do not always align with the theory's predictions.

“It is possible our assumptions about how active managers differ from their index peers could be wrong,” said the group. “For example, active managers in the large-growth category could have a larger-cap orientation than their index peers, explaining why they might benefit from weaker performance among small-cap stocks.”

The best explanation for issues with Dunn’s Law however is the simple fact that success rates among active managers are ‘noisy’.

While possible that some periods may be more conducive to stock picking than others, success across active managers is not highly correlated, so success rates are partially driven by luck of the draw, added Morningstar.

Just as it is difficult to predict when the general market will do well, it is hard to predict when certain investment styles will be in favour. With that in mind, the group concludes it is best to accept active managers' success rates will be volatile and not try to time exposure between active and passive funds.

For our part, as we have said, we believe a blend of active and passive funds is appropriate for the majority of investors. It is all about finding the right tool for the right job – or, in this case, the right market.

In the short to medium term, we continue to believe passive funds will offer adequate returns in line with a chosen index; if investors want outperformance over the long-term however, exposure to active managers will be required. It should not be forgotten that the last decade of passive ascendancy has come against largely rising markets but as recent months has served to remind us all, markets can very much go down as well as up and there is nowhere to hide when you are tracking a falling index.

Ultimately, trying to time anything when it comes to investing has proved all but impossible over the long term. Rather than looking to invest according to Dunn’s – or any other – Law then, we continue to advocate long-term patient portfolios using active and passive funds according to what market and macro conditions, valuations, and ultimately opportunities to enhance returns within our risk targets highlight as most appropriate.

The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. Past performance is not a guide to future performance. The portfolios' investments are subject to normal fluctuations and other risks inherent when investing in securities. Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use. This article is for information only and should not be deemed as advice.