Research by Sharpe in 1992 showed that style and size explain roughly 80-90% of mutual fund returns. A more recent study by Morningstar (domestic equity funds from 1/1991 to 12/2011) confirms Sharpe’s general analysis. According to the Morningstar study, the average correlation of the respective fund to its Russell index (either the Russell 1000, Russell Mid Cap, or Russell 2000) was 0.94; this translates into an R-squared (coefficient of determination) of 86%. However, the correlation has not been constant.
According to Morningstar, since 1991, the average correlation for actively managed domestic equity funds has been increasing. As of December 2011, the average fund had a 98.2% correlation to its respective category index. This means that 98.2% of an actively managed domestic fund’s return is due to its underlying benchmark index. This suggests that active management only added ~ 1/30th of the total deviation in returns (while still having ~ 10 times the expense ratio of a passively managed fund).
Another way to look at these correlations is to consider the standard deviation (SD) of the correlations. The SD metric captures the dispersion of all active management over time. The results of this analysis do not bode well for advocates of actively managed domestic equity funds. The average rolling category correlation has been decreasing over time. This decrease suggests that an increasing number of active funds are clustering more and more tightly around their respective category benchmarks.
The final test of determining the direction of active domestic equity funds is based on the average tracking error of the fund vs. its respective category index. Excluding two major spikes (in 2000 and lates 2008), the clear trend has been a decreasing level of tracking error.