There has been much publicity about active managers’ inability to beat their benchmarks over the years.
However, upon closer inspection, funds that have remained truly active have shown ability to add value above their benchmarks. A study conducted by Yale professors Martijn Cremers and Antti Petajisto set out to find variables that could help predict fund performance. One variable was active share, which measures a fund’s percentage of holdings that differs from the benchmark index. For example, an index fund has an active share of zero percent and an active fund with no benchmark overlap has an active share of 100 percent. They found that active share is predictive of excess returns. Their study showed that funds with the highest active share and moderate tracking error outperformed by about 1.5 percent per year on average while funds with the lowest active share underperformed by a similar amount.¹
The mutual fund industry has evolved over the last 35 years, from an environment where most fund managers had portfolios significantly different than their benchmarks, compared to today where many have high benchmark overlap. In 1980 only 1.5% of fund assets had active share below 60% compared to 40% of fund assets at the end of 2009. Additionally, share of mutual fund assets in very active funds (80-100% active share) decreased from 60% to less than 20% over that same time period. Closet indexers (20-60% active share) now make up about a third of mutual fund assets.² A closet index fund is a particularly bad deal for investors as they will produce returns similar to the benchmark before fees and so are destined to underperform that benchmark by the amount of the fund’s fees. It is no coincidence that the cumulative excess returns of the median active fund peaked in the early 1980s and have steadily eroded with the proliferation of closet indexing.
The merit of active share is intuitive. If a fund is too similar to the benchmark it is trying to beat, the fund can’t generate enough excess returns to overcome fees charged to the investor. Furthermore, the key to outperforming over time is to consistently apply a well-defined process. If a manager has a well-defined process which seeks specific characteristics in a security, by definition it should produce a portfolio that is significantly different than the benchmark most of the time.
However, all active share is not created equal. Tracking error, which measures the variability of returns compared to the benchmark, is another important piece of the puzzle. Funds with very high tracking error tend to have large factor or sector bets that result in high volatility of returns compared to the benchmark. Cremers and Petajisto found that high active share managers that focused on stock selection within a diversified portfolio, while mitigating tracking error, had the best results. This group is represented by funds in the highest quintile of active share while excluding the highest quintile of tracking error. Funds with high active share and high tracking error and substantial factor bets were the worst performing sub group.³ In other words, managers who focus on stock selection as an alpha driver produced better results compared to managers that take large sector or factor bets.
Active share is just one factor to consider when selecting fund managers. Obviously, if a manager lacks skill and a sound investment process, high active share will only increase the risk fiduciaries are trying to minimize. NFP Retirement’s Scorecard is in place to reduce this risk and help fiduciaries identify the skillful managers. Used in conjunction with high active share and moderate tracking error, the evidence suggests that active managers can add value.
~ Geoff Keeling, CFA, Investment Analyst
About the Author, Geoff Keeling, CFA
Geoff Keeling joined NFP Retirement as an Investment Consultant in November 2014. In this position, Geoff utilizes his deep asset-management experience and perspective in providing best-in-class investment due diligence consulting to plan sponsor clients. Geoff plays an integral role in NFP Retirement’s Investment Committee, where all quantitative and qualitative aspects of the investment due diligence process are vetted and discussed when providing manager recommendations at the firm level for the firm’s entire client base. He brings with him over 15 years of investment experience. Prior to joining NFP Retirement, Geoff was a Managing Director and Senior Portfolio Manager with Invesco in Houston. Geoff was a lead manager on the Invesco Large Cap Growth Fund since inception and managed over $3 billion in client assets. During his time at Invesco, Geoff was featured in Investor’s Business Daily and appeared on CNBC. He began his investment career in 1995 as an Equity Analyst for AIM Investments. Geoff is a CFA® charterholder and member of the CFA Society of Orange County. He graduated from the University of Texas at Austin with a BBA in Finance.