This is the final installment of Ed Rempel’s series on active investing.
“If you can’t imitate him, don’t copy him.” – Yogi Berra
In the last article, we introduced the concept of “Active Share” – the degree to which the holdings in a fund differ from the index – based on a study by 2 Yale academics.
Here are some of the other valuable insights from the study.
Fund Manager Insights
The study identifies different types of fund managers and evaluates their success by comparing both Active Share and correlation to the index (“tracking error”):
- Low Active Share/Low Tracking Error: “Closet indexer”. These were the worst performers.
- Low Active Share/ High Tracking Error: “Sector bet”. These fund managers have many of the index holdings, but take big bets in sectors. These funds also underperformed with returns similar to “closet indexers”.
- High Active Share/Low Tracking Error: “Diversified stock picker”. They tend to have many holdings –but different ones than the index. They are often skilled stock pickers. Their funds move somewhat like the index just because they are quite diversified. They tended to outperform.
- High Active Share/High Tracking Error: “Concentrated stock picker:” They tend to have fewer holdings. These are the bravest fund managers, since it takes courage to both hold larger positions and be very different from the index. They tended to outperform.
The study defines “closet indexers” as funds with an Active Share of 0-60%. The most negative aspect of the rise of index investing is that closet indexers have proliferated even more than actual index funds. They are now about 30% of equity mutual funds, up from virtually zero in 1980. In 1980, virtually all fund managers were truly active (very different from the indexes).
Closet indexers obviously underperform! Their holdings are similar to the index, and yet they generally charge similar fees to truly active funds. They are probably the worst choice of equity investments, since you are probably not getting either a skilled fund manager or a low cost.
I have to admit that my eyes glaze over when I look at a Canadian equity mutual fund with the top 10 holdings including 3 or 4 banks, plus a couple of the largest insurance, oil and gold companies. They have all the same holdings as the index, but a 2.5% MER! How can they possibly outperform?
One of the main conclusions of the Yale study is that really nobody should own a closet index fund. You should either have a truly skilled fund manager (with a high Active Share) or a low-cost index fund, but nobody should pay the full cost of a skilled fund manager for a closet indexer.
One common strategy for closet indexers is “window dressing”. They fill their top 10 holdings at month-end with popular stocks. Recently, Canadian banks have been popular so they may add them to their top 10 in the last day or 2 of the month, but then dump them right after month end.
Despite this, closet indexers have become very popular for many reasons. Investment salespeople like them because they are easy to sell. Investors like to see big, solid companies they know in the top 10 holdings and are more comfortable during market declines if everyone else is down at the same time. Investors tend to think they are “safer”, but the study showed they are no less volatile or risky than truly active funds with totally different holdings.
Most fund managers are just salaried employees trying to keep their jobs. They have learned that “You don’t get fired for owning Microsoft or Royal Bank”. They know that: “It is better to fail conventionally, than succeed unconventionally.” (John Maynard Keynes).
You can usually identify closet indexers by the way they talk about being underweight or overweight some sector. It is hard to argue that they even try to outperform, since they try to have similar holdings and sector weightings to their indexes with much higher fees.
This proves the saying: “You can only beat the index by being different from the index.”
The study defines “sector bets” as funds that try to outperform by being in the right sector, as opposed to picking the rights stocks. These funds tended to own companies in the index, but were heavily overweight in some sectors. They may be “sector rotators” or “market timers”. Think of it somewhat like actively switching between several sector funds or sector ETFs.
Some investors today use a strategy like this by trying to market time ETFs in various sectors. The study showed that, while top fund managers can be great stock pickers, even top fund managers were not able to outperform by market timing sectors.
Active Share Predicts Outperformance for “Stock Pickers”
The hardest part of finding skilled fund managers is identifying them ahead of time. It is easy to look at recent returns and see who performed best in the past.
Part of the pitch by most investment salespeople to sell their investments is to show recent returns of the funds they are recommending. One of the main arguments for investing in index funds is that, while there are fund managers that outperform, how do you identify them ahead of time?
However the Yale study showed that: “Active Share predicts fund performance. Funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence.”
Fund managers with high Active Share that outperformed the prior year and prior 3 years tended to continue to outperform, but this was not the case for funds with low Active Share.
In addition, fund managers tend to maintain their Active Share. For example, most of the funds with an Active Share of 90-100% stayed there over each of the next 5 years.
This does not mean that all managers with high Active Share outperformed, but the average fund in the group significantly beat their index even after all fees.
To be clear, “active” managing does not necessarily mean they are buying and selling a lot inside their fund. A high Active Share means they the fund manager is “actively” picking stocks (not passively being an index). “Active’ does not refer to activity level but the degree to which the funds’ holdings are different from their index.
The study does a long way to prove its credibility. The initial study was U.S. funds, which is the hardest place to beat an index. This is probably the most comprehensive study on the topic. It includes daily stock and fund values for 24 years, compares every fund to 19 different indexes, identifies index funds and closet indexers, and includes dividends and all closed funds (no “survivorship bias”).
I wondered at first whether there was some hidden factor that would explain this. For example, perhaps the fund managers with high Active Share are buying smaller companies? The study exhaustively evaluates the contribution from many possible factors to see how they contributed to outperformance and to Active Share.
They filtered the results for many factors, including size of holdings, size of fund, momentum, cash position, “tracking error” correlation to the index, turnover of holdings, expenses (MER), number of holdings, age of fund, manager tenure and cash in-flow/out-flow.
The results showed that fund managers with high Active Share tended to outperform significantly even after taking all these factors into account.
The other factors that contributed the most were:
- Size of fund: Managers with a high Active Share outperformed by wider margins with small and mid-sized funds, than in larger funds (over $1 billion).
- Expenses (MER): There was a slightly higher MER with managers with higher Active Share. Closet indexers tended to have MERs nearly as high as the top fund managers. You may have thought that lower fees would lead to higher returns, but the study showed that the top performing funds with high Active Share tended to have slightly HIGHER fees.
- Manager tenure: Experience makes a difference.
The study showed that combining factors can make a much bigger difference. For example, for the smallest 10% of funds that have an 80-100% active share and outperformed the prior year, they beat their index on average by 6.5%/year after all fees! That’s a lot.
The main conclusions of the study are:
- The more different a fund is from the index, the better it tends to perform!
- Nobody should own a closet index fund. You should either have a truly skilled fund manager (with a high Active Share) or a low-cost index fund, but nobody should pay the full cost of a skilled fund manager for a closet indexer.
About the Author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching. If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com. You can read his other articles here.
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