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Not All Active Managers Are Poor Performers

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Many advisors would agree that blending passive and active equity strategies is an effective way to ensure portfolios contain both inexpensive beta as well as alpha designed to grow assets over the long term.

Identifying cost-effective exchange-traded funds to include in a portfolio is a relatively simple task, but finding the right active funds to complement the passive strategy can be considerably more challenging. Sowing added confusion meanwhile are the frequent headlines declaring that, on average, active managers consistently underperform passive strategies.

Industry-wide performance numbers that attempt to assess the entire universe of actively managed funds are by definition often misleading. Active funds can vary widely. There are those with very low active share measures. Known as “benchmark huggers,” their holdings stray little from the benchmark. Standing in contrast are those with very high active share measures. Holdings highly differentiated from the benchmark characterize their managers as active stock pickers.

The role of advisors, and the degree of responsibility they owe their clients, has been under the microscope of late, particularly with recent attention on the fiduciary standard. That means it is more important now than ever to understand how to distinguish truly active, high-performing funds from low-performing closet indexers that may not answer clients’ long-term needs.

Understanding the Data

By analyzing funds individually, we can see that not all active managers are poor performers. However, we also know that many research reports emphasize how poorly active managers fare when weighed against passive strategies. Many studies have weaknesses, such as focusing on the performance of the “average” active manager or using results biased by the impact of the most recent market environment on relative performance. Few studies isolate the degree of active management evident among strategies.

According to research from the University of Notre Dame Mendoza College of Business, it makes far more sense to isolate high active share funds from low active share funds when analyzing the performance of active funds. That’s true because studies have found that funds with low active share characteristics have consistently underperformed their benchmarks, while high active share funds outperformed their benchmarks.

The research, conducted by Professor Martijn Cremers — one of the co-originators of the active share concept in 2009  — covers active fund performance during the period 1990-2015 in the U.S. (Cremers serves as an independent consultant for Touchstone Securities.) This study looks at a sample of 3,100 funds with at least 80% invested in U.S. equities and at least $10 million in assets under management. To analyze performance in relation to their active share levels, Cremers divides the mutual funds into five quintile groups (i.e., each group consisting of 20% of the funds existing at that time, based on their active share at the end of the previous calendar year). During the 25-year period studied, mutual funds in the lowest active share quintile group underperformed their benchmarks by 137 basis points, while the highest active share quintile outperformed their benchmarks by 71 basis points, net of fees.

It is especially important to consider avoiding funds with low active share that are expensive. The research showed that the funds in the lowest active share quintile group with the highest fees underperformed their benchmarks by 229 basis points net of fees.  The research also demonstrated that the higher the fees were for the low active share funds, the worse their performance. Such results correspond well to conventional wisdom among fund researchers, advisors and investors.  However, many investors will find the performance results of high active share funds run counter to what they’ve been led to believe. For funds in the highest active share quintile group, Cremers’ research showed no evidence that higher fees are related to underperformance of the benchmarks.

Only about 30% of U.S. assets in mutual funds are currently in funds with an active share of at least 80%, and only about 10% of assets are in funds with an active share of at least 90%, according to Cremers. When we consider that a large percentage of U.S. equity mutual funds are not truly active stock-pickers, we can appreciate how important it is to separate the wheat from the chaff.

Active or Not: Determining Who’s Who

To compare actively managed funds, advisors can consult, a free website run by Cremers. Advisors can match as many as four different funds at once to gauge which are most and least active. The site provides data on current and historical active share and equity allocation. It includes a fund’s holding duration, the weighted average amount of time current stocks in the portfolio have been held within the past five years, which serves as a measure of a manager’s conviction. With two to three years as the average duration for U.S. equity funds, this number helps assess how patient managers are with their stock picks. The site also includes a fund’s “active fee,” which rescales a fund’s expenses for its active portion, identifying the manager’s hurdle rate to earn back the fees through the portfolio’s active component alone.

My firm believes investors must not rely on active share as the only important element of manager evaluation. Cremers’ recent research has focused on combinations of active share with other critical characteristics of effective investment management, suggesting managers must also be skilled when selecting portfolio companies, have conviction in their investments, possess the right opportunity set to implement a highly differentiated strategy and have patience to stick with their choices. In addition, expenses must be reasonable relative to the active management exposure offered.

Truly Active Means Truly Different

Whatever data advisors choose for their active manager due diligence, they should ensure their research considers active share, along with other manager characteristics and expenses.  If investing similarly to the benchmark is simply asking for benchmark-like results, why pay active fees for that result?

Advisors owe it to their clients to ensure that the “active” portion of a portfolio is truly active. Active share is an important metric for isolating strategies that are truly different. And that’s a great starting point for active management evaluation.

— Please consider the investment objectives, risks, charges and expenses of a fund carefully before investing.See Steve’s bio page for a full disclaimer.


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