To say that active management has fallen out of favor in academic finance is like saying that leeches have fallen out of favor in medicine. An author who dares to suggest that active mutual fund managers provide value generally causes journal reviewers to reach for their pitchforks.
Two recent articles by Antti Petajisto, former NYU assistant professor and now vice president for BlackRock’s multi-asset strategies group, buck this trend. Petajisto finds that a lot of active managers don’t do much. Since they charge higher fees than passive funds, it’s natural that they will underperform. Other active managers try to do something. And that’s where things get interesting.
Petajisto’s 2009 article, co-authored with Yale Professor Martijn Cremers and published in the Review of Financial Studies, found that the percentage of mutual fund assets that were managed passively increased steadily through the 1990s and 2000s. The problem is that not all of these passively managed funds were index funds. Some called themselves actively managed funds, charging management fees that suggested they did something other than play golf and enjoy three-martini lunches. These are the so-called closet indexers. They don’t do well.
The percentage of passively managed fund assets has risen from about 10% in the mid 1990s to about 50% now. But only about 20% of these fund assets are held in pure index funds—the other 30% are held in actively managed funds that essentially hug the benchmark. The other half of mutual fund assets are invested in funds whose asset holdings deviate substantively from their benchmark. These are, presumably, the ones who identify stocks or sectors they believe are undervalued. In other words, they try to do something.
As it turns out, the ones who did something were able to achieve a positive risk-adjusted return net of management fees (see nearby table).
In their research, Cremers and Petajisto introduce a new measure called “active share,” which describes the extent to which managers deviate from the allocation to stocks within their benchmark. So if a mid-cap growth manager decides that Tesla has become overvalued and underweights the stock and decides to overweight Yahoo!, this will create a deviation from the benchmark. More deviation means more active share. Active share seems much more closely related to the ability to generate alpha than tracking error.
Cremers and Petajisto show that the more the fund deviates from the benchmark, the better it performs. And the relationship appears surprisingly linear and consistent. The more work they do, the higher the alpha net of fees. The gold standard of fund performance is persistence. Are yesterday’s high active-share funds going to outperform tomorrow? Funds with high active share today are significantly more likely to have high active share in five years and to outperform other active funds.
Money for Nothing
The flip side of the exciting research in active share is that it identifies a large segment of the mutual fund universe that appears to be inactive. In a paper titled “Money for Nothing,” American College assistant professor David Nanigian and I investigated whether managers who did more work charged higher fees. It turns out that they do. Closet indexers charge less, but they still charge a lot more than the expense ratio on pure index funds. This leads to two questions. Why would anyone invest in an active fund that does nothing? And why aren’t more fund managers trying to do something?
Closet indexing may be related to fund marketing. Studies have found that excess performance attracts a lot of new investor cash. But once in the fund, investors tend to be less sensitive to returns unless a fund crashes. So the optimal strategy is to work to attract new investor funds, and then sit back and track the index to avoid the possibility that you’ll do significantly worse than the benchmark. If existing investors are happy with average returns, then there’s no reason to rock the boat.
Nanigian thinks that the risk of deviating from an index can help explain why so many actively managed funds have a low active share. “When a fund manager chooses to deviate from her benchmark she is taking a risk that she will underperform the benchmark.”
Indeed, a 2012 report on active share by Vanguard finds that excess performance, positive or negative, rises with active share. Since a manager’s compensation and continued employment may be threatened by underperforming the benchmark, Nanigian believes that hewing close to the benchmark is a safer bet. “Acting in self-interest, it makes sense for them to engage in closet indexing.”
In Petajisto’s newest paper to be published in the Financial Analysts Journal this year, he identifies 180 closet indexing funds. The 180 most active funds (he calls them the “stock pickers”) hold $480 million in assets while the 180 closet indexers hold over $2 trillion. The expense ratio of the stock pickers is 1.41% on average while the closet indexers charge 1.05%. The net alpha of the stock pickers, however, is 1.89% annually versus -1.07% for the closet indexers between 1990 and 2009.
Unfortunately, those closet indexing active fund owners hold what is essentially a really expensive index fund. Although expense ratios are lower for the closet indexers, their expenses will always equal their underperformance.
Is Active Share Valuable?
A recent research report by Vanguard questions whether the hype over active share might be overblown. Using a more recent time period, 2001-2011, there is little evidence that funds with greater active share performed better. And there appeared to be little persistence in 2006-2011 performance among more active fund managers who performed well between 2001 and 2005. Petajisto’s most recent study, however, shows that stock pickers (measured through active share) outperformed during the full 1990 through 2009 time period, and that they also outperformed during the financial crisis of 2008 and 2009.