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April 03, 2017 at 08:00 PM
While the fate of the Department of Labor’s new rule for retirement advisors is unclear under President Donald Trump’s administration, its impact continues to be felt in the increased awareness among investors and their financial and legal advisors that some retirement advisors and plan sponsors haven’t been living up to their fiduciary responsibilities.
This awareness has touched off a flood of lawsuits, charging the use of “expensive proprietary funds,” “expensive, poor performing investments” or “excessive recordkeeping fees,” against the pension plans of some of the largest institutions in the country, including Wells Fargo, Fidelity, Neuberger Berman, Starwood Hotels, Verizon, Chevron, Intel, Oracle, American Airlines, Deutsche Bank, Putnam Investments and Allianz, as well as MIT, NYU and Yale University.
What’s more, this new focus on investment costs has been at least partially responsible for the $506 billion that flowed into ETFs and index funds in 2016, while, according to Morningstar, $341 billion flowed out of actively managed funds. That’s unfortunate: It’s far from an established fact that at least some actively managed funds don’t deliver value to investors in excess of their higher fees. In fact, quite the opposite was clearly demonstrated by Martijn Cremers and Antti Petajisto of the Yale School of Management in their 2006 paper on “Active Share.” Cremers has taken that one step further with the introduction of the “Active Fee” calculation, which quantifies the value to investors of successful active investing.
(Related: Active Managers’ Struggle to Maintain Assets)
In that first paper, Cremers and Petajisto examined the performance of 2,650 mutual funds during the period from 1980 to 2003. They found that those funds with an Active Share of 80% or higher (that is, funds holding 80% or more stocks that were outside their benchmarks) beat their benchmark indexes on average by 2% to 2.71% before fees, and 1.49% to 1.59% after fees, per year. That is, not only can active management outperform the benchmark indexes over time, the best active managers do so even after fees.
What’s more, Cremers and Petajisto showed that the best active fund managers not only had the highest Active Share, they also had very clear systems for determining which stocks to buy, were extremely disciplined in applying that system and, perhaps most importantly, had a buy and hold commitment to those stocks, even during periods when they underperformed.
Revisiting Active Share
In his new paper, “Active Share and the Three Pillars of Active Management: Skill, Conviction and Opportunity,” Cremers, now at the Mendoza College of Business at the University of Notre Dame, takes a deeper look at the factors that support superior mutual fund performance. He proposes the above mentioned “Active Fee,” which, at least to my mind, just might demonstrate a “reasonable basis” for recommending some actively managed funds, rather than ETFs or index funds, in investors’ portfolios.
In a large sample of actively managed retail U.S. equity mutual funds between 1990 and 2015, Cremers found that funds with low Active Share and relatively high expenses underperformed, “while the level of expenses seems unrelated to performance for high Active Share funds. This indicates that investors in funds with low Active Share should carefully monitor the amount they pay.” Short-term stock pickers also tended to underperform.
Cremers also found that “small-cap funds tend to have higher Active Shares and better performance than large-cap funds, which suggests that small-cap managers have better stock picking opportunities in general.”
The insight behind Cremers’ Active Fee is that when actively managed funds hold stocks that are also held by their benchmark, that fund’s investors could get that same exposure by simply buying that index, at a cost that presumably would be substantially lower than that of the actively managed fund. Simply put, investors in actively managed funds are overpaying for the portion of their funds’ holdings that also appear in the funds’ benchmark.
Cremers offers this example. If an actively managed fund has an Active Share of 49% (that is, 51% of the fund’s holdings are also in the fund’s benchmark) and an expense ratio of 0.84%, while the expense ratio for its benchmark equals 0.15%, its Active Fee would be (0.84% – 51% * 0.15%) ÷ 49% = 1.56% per year. “The difference between the Active Fee of 1.56% and the 0.15% cost for the benchmark equals 1.41%, the ‘hurdle rate’ for the manager,” Cremers wrote.
