MYTH: Active underperforms if the manager's style box is out of favor

November 23, 2018

Chris Tidmore

Chris Tidmore
Senior Investment Strategist

REALITY: What appears to be active under- or outperformance may be an issue of style purity.

Investors have long attributed the success or failure of an active manager to whether the manager's investment style is in or out of favor. Let's evaluate this performance attribution based on the oft-used style box.

Many active U.S. equity managers tend to manage portfolios whose general characteristics fit into one of the nine categories in the style box (see graphic below). The style box categorizes stocks as large, mid, or small capitalization and also classifies them according to value or growth characteristics or a blend of both. When analyzing the performance of active investments through the lens of the style box, we found a phenomenon associated with the categories that affects the likelihood of success in active management, but not in the way you'd think.

Investment focus

Investment Focus

There's an axiom in investing called Dunn's Law, or style purity.1 It holds that active management tends to underperform its index in the highest-returning segments of the market and outperform its index in the lowest-returning segments of the market.

We assessed the performance of actively managed funds in the context of the performance of the nine style boxes over the 26 years ended 2017. What we found was consistent with Dunn's Law: As a style box's relative performance increased, the percentage of outperforming active funds decreased. As a style box's relative performance decreased, active managers tended to do better.

Investment Focus

Source: Morningstar, Inc., as of December 31, 2017.

Notes: U.S.-domiciled active equity funds, nine-style box, all share classes, one-year annualized excess returns versus style benchmark, year-by-year analysis.

Why does Dunn's Law work?

Why would Dunn's Law work for active funds? Because most active managers, even when they concentrate on a particular style, typically invest outside that style, as illustrated in the graphic below. In other words, an actively managed fund may be a large-cap growth fund, but it will also likely contain some blend and mid-cap stocks, and it may also hold some cash. As a portfolio invests more outside of its style, it is considered less "style pure." So when the fund's targeted style is doing relatively poorly, the fund's investments that are categorized outside that asset class may do relatively better, helping the active manager to perform better. Of course, the opposite is also true: When the fund's targeted style is doing relatively well, the fund's investments that are outside that asset class may do relatively worse, causing the active manager to perform worse.

Investment Focus

Central tendency. The fund's central tendency reflects the aggregate characteristics resulting from the fund's approach to security selection. Because it is based on an analysis of the performance characteristics of the fund's potential holdings over long periods, the central tendency is expected to be relatively stable. In the style box, it is shown as a dot within the shaded oval.

Expected range. Within the fund’s universe of potential holdings, and depending on the fund’s investment approach, some categories of investments will be owned more frequently; together, they are known as the expected range. In the style box, the expected range of frequently owned categories is represented by the shaded oval.

That does not mean that active managers have more skill when times are tough. It simply means they have invested portions of their portfolios outside of their style box.

No one can tell the future

So can you use Dunn's Law as a way to invest? It may be a stretch. First, you would have to know, or be extremely confident, that you could predict which portion of the market will underperform the most in the future. If you could predict that, why would you ever invest in that segment during that time period? The better choice would be to simply avoid it.

But that's an unlikely scenario. The reality is that it's notoriously difficult to predict how any segment of the market will perform in the next year, much less over the next several years. The graphic below shows how market leadership changed every year over the past six years.

Stock fund categories ranked by performance, December 31, 2011, to December 31, 2017

Investment Focus

Source: Vanguard.

Note: Investors cannot invest directly in an index.

How to succeed with active

Some active managers closely hew to style purity. Other managers allow their portfolios to drift significantly, which makes their performance difficult to evaluate against a benchmark. They may perform very well in difficult times but underperform just when their segment of the market shines.

Index funds can be a great place to start, but we believe actively managed funds can also play an important role in building a diversified portfolio. To succeed with active managers, you need to choose top talent, at a low cost, and then practice patience through the inevitable ups and downs in the financial markets. Also remember that if you're looking to combine various active managers with passive investments, it will be important to understand the bets the active managers are making outside their style benchmarks.

To learn more about how to use active management, see Making the implicit explicit: A framework for the active-passive decision.2

For additional insight into active management myths, see MYTH: Active management performs better in bear markets and MYTH: Active performs better in certain market segments.

Download a copy of MYTH: Active management underperformed because their style box was out of favor. You can also access the piece by logging on to our Literature & forms page and ordering a copy.

1 William J. Bernstein, 2000. The Dunn's Law review. Efficient Frontier. Accessed July 25, 2018, at

2 Daniel W. Wallick, Brian R. Wimmer, Christos Tasopoulos, James Balsamo, and Joshua M. Hirt, 2017. Making the implicit explicit: A framework for the active-passive decision. Valley Forge, Pa.: The Vanguard Group.


  • Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility
  • All investments are subject to risk, including the possible loss of the money you invest.
  • Past performance is no guarantee of future returns.
  • Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks. Investments in stocks issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.

CFA® is a registered trademark owned by CFA Institute.

Chris Tidmore, CFA, is a senior investment strategist in Vanguard Investment Strategy Group, where he leads the team that conducts research and provides thought leadership on issues related to active management. Before joining Vanguard in 2015, Chris managed the Geneva Arbitrage Fund, which focused on event-driven investment strategies. Before the launch of the Geneva Arbitrage Fund, he worked as an arbitrage trader and portfolio manager for a large family office. In addition, he was an options trader on the American Stock Exchange, and prior to his work in the securities industry, he was employed as an auditor, providing audit, accounting, and consulting services.

Chris has developed and taught courses in financial accounting, financial statement analysis, asset valuation, equity derivatives, trading, portfolio management, alternative investments, and CFA and CPA review courses. He earned a B.S. in accounting at the University of Delaware and is a CFA® charterholder, CPA, and past president of the CFA Society of Philadelphia.


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