For Martijn Cremers, co-creator of the active share measure, the ideal actively managed mutual fund is led by a manager who is supported by three pillars: skill, conviction and opportunity.
“You need all three to be successful in the long term,” says Cremers, whose recently published study can help advisors distinguish between actively managed mutual funds that are primarily closet index funds and those that are truly actively managed by skilled stockpickers.
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Active share is a measure of how distinct a portfolio is from its index benchmark, but it doesn’t necessarily indicate whether a fund will outperform its benchmark. That ability depends on the three pillars.
Skill is the ability of a manager to identify good investment opportunities, not just investments that are outside of a benchmark, says Cremers, a professor of finance at the University of Notre Dame, who spoke with ThinkAdvisor recently.
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Funds can have a large active share but still underperform if their managers lack investment skill. “Active share is not a measure of skill,” says Cremers. “It’s a measure of how distinct a portfolio is.”
Conviction is a manager’s willingness to maintain positions for the long term — a minimum of roughly three years, according to Cremers. Patience is one measure of conviction, but “being patient in an impatient world is difficult to do,” says Cremers, describing the current investment environment where managers are evaluated based on short-term performance, be it monthly, quarterly, semiannually or annually.
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The best performing managers will also exhibit the courage of their convictions, daring to be different, using strategies that are not easy to replicate, says Cremers. A manager may be right over three years, for example, but wrong for the next 6, 12 or 18 months. Will she have the courage to stick with the strategy?
Opportunity is the ability of managers to use their stock-picking skills without constraints that could limit their ability to maintain a high active share. Opportunity is especially important for large-cap equity funds because large-cap funds with low active share tend to underperform, but large-cap and small-cap funds with patient strategies (conviction) and high active share outperform on average, says Cremers.
Fees are another important variable for advisors to consider when choosing among actively managed funds, specifically those funds with low active share, says Cremers. Fees are not an important factor for high Active Share funds.
A fund’s fees defines “the hurdle rate” that the manager has to top in order to outperform a benchmark index fund. The higher the fees, the higher the hurdle rate, says Cremers.
He proposes that advisors and investors use a measure he’s calling “active fee,” which is essentially the cost for a fund’s active stock-picking. It’s calculated by dividing the expense ratio by a fund’s active share, minus the cost of investing in a benchmark index fund.
For example, a fund with an expense ratio of 0.75% and an active share of 50% that is benchmarked against an index fund that costs 0.15% has a hurdle rate of 1.35% (0.75%/0.50% = 1.50% – 0.15%). A fund manager would have to outperform his benchmark index by 1.35% for the fund to be worth buying, and the bigger the outperformance the better the buy.
Cremers says he’s found “no problem with low active share as long as they’re cheap.”
Touchstone Investments incorporates Cremer’s active share measure in all its mutual funds, which it describes as “distinctively active.” Its president, Steve Graziano, says Touchstone funds have a high active share as they focus on stocks of companies with competitive advantages that they can hold onto for years. The funds tend to be concentrated, with a limited number of stocks compared with other actively managed funds in their category, reflecting the managers’ best ideas.
For example, the Touchstone Sands Capital Select Growth Fund has an active share of 84 compared with a 69 share for the top 50 large-cap growth funds, and 31 stocks, versus an average 126 in the category — “large bets on companies the portfolio managers believe in,” says Graziano.
Performance is variable. The fund ranked in the top decile for three to four years but then underperformed in the last three, says Graziano. “It’s not a bad fund. It will create wealth in the long run if you stick by it.” But he admits that it may get overlooked because investors are “losing sight of good managers.”
Morningstar’s Dan Culloton, director of manager research, equity strategies, wrote in a September analysis that “the fund can look streaky in the short term but impressive over longer terms,” paying off for the patient investor. “It has never lagged the large-cap growth category average in any rolling 10-year period and has beaten the Russell 1000 Growth Index in 93% of those spans.” But he warns, “Risk tolerance required.”
The Benefits of High Active Share
Cremers, a consultant to Touchstone Investments, says the typical high active share fund has an active share in or near 80% for large-cap funds, 90% for mid-cap funds and 95% for small-cap funds.
“Active share matters for investors,” writes Cremers in his latest report. “First, Active share allows investors to distinguish between funds that do and do not engage in a lot of stock picking.
“Second, by avoiding low–active share funds that are not cheap, investors are more likely to avoid underperforming funds, which will probably remain the case in the future.
“Third, active share may be helpful in deciding which actively managed funds to invest in.”
Cremers “found no evidence that high-active-share shares underperform on average in the long term, suggesting that investors interested in individual stock pickers could use high active share as a starting point for fund selection.” But they should realize that the “typical high–active share fund will either underperform or outperform.”
Advisors can consult the ActiveShare.info website created by Cremers to check the active share percentage of a particular fund.
— Related on ThinkAdvisor:
- Active Managers’ Struggle to Maintain Assets
- Active vs. Passive? No Longer an Either/Or Choice for Advisors
- Active Share Is No Way to Pick a Mutual Fund: AQR
- Index Funds Outperforming, and Outlasting, Active Funds: Morningstar
- How BlackRock’s Active Funds Revamp May Hurt Competitors but Help Advisors