A new paper lays out a way to evaluate opportunities in active funds.

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.

That hurdle rate is what the fund has to generate on the active 49% of its holding each year to compensate investors for charging them an active management fee on passive fund holdings.

“The main empirical prediction that follows,” concluded Cremers, “is that expense ratios should be more negatively associated with fund performance for low Active Share funds as compared to high Active Share funds.”

Cremers’ second foundation of active investment management is conviction, which he described as “the willingness to translate identified investment opportunities into a portfolio that is sufficiently different to outperform in the long term.”

Cremers found that only high Active Share funds with long holding durations outperformed on average, while frequently traded funds underperformed. “This provides empirical support […] that long-term mispricing is more subject to limited arbitrage than short-term mispricing, resulting in greater profitability for those managers able and willing to invest in patient active strategies.”

However, he noted that long-term holding strategies are subject to increased risk for fund managers due to “the possibility that they may underperform in the short term,” and short-term underperformance may “jeopardize the manager’s ability to retain the assets and continue the long-term investment strategy (especially in case of impatient investors).”

The third pillar of Cremers’ successful active management approach is opportunity. “A high Active Share indicates a relative lack of constraints” on the manager, he wrote. “If small caps generally have greater information uncertainty or less efficient pricing than large-cap stocks, this would predict that high Active Share funds perform better among small-cap funds than among large-cap funds.”

Cremers found limited evidence for this theory. “On the one hand, large-cap funds with low Active Share strongly underperform, while we find no evidence for underperformance among small-cap funds, even those with low Active Share,” he wrote. “On the other hand, funds that combine [patience] with high Active Share strategies outperformed on average both among large-cap and small-cap funds.”

Cremers concluded that Active Share matters for investors in three ways. First, it allows an investor to distinguish between funds that engage in a lot of stock picking. Managers who pick stocks, as opposed to mirroring an index, have a greater chance of outperforming, which translates into value for their shareholders.

“Second, by avoiding low Active Share funds that are not cheap,” he wrote, “investors would have been more likely to avoid underperforming funds, which is likely to remain the case in the future.”

Finally, Active Share may be helpful in selecting actively managed funds that are likely to outperform. “We find no evidence that high Active Share funds have underperformed on average in the long term,” Cremers wrote, “suggesting that investors interested in individual stock pickers could use high Active Share as a starting point for fund selection. […] High Active Share managers can be expected to be most successful if they also follow strategies that are more difficult to implement — such as patient strategies requiring a higher level of investor trust and manager conviction.”

As I said, identifying the Active Share component of actively managed funds, together with the new Active Fee calculations that identify how much investors are paying for truly active management, may go a long way toward helping investment advisors and plan sponsors justify their inclusion of actively managed funds in today’s index-oriented world.

— Read How BlackRock’s Active Funds Revamp May Hurt Competitors but Help Advisors on ThinkAdvisor.