This is another controversial guest column by CFP and CMA Ed Rempel.  Note that this article does not necessarily represent the views of this website.

“We were overwhelming underdogs.” – Yogi Berra

The popular opinion among investors supported by many studies claims that most fund managers underperform their index, so you are better off just investing in an index fund or ETF (Exchange Traded Fund). However, truly “active” fund managers have significantly outperformed their indexes after all fees over the long term, based on a very comprehensive study by 2 Yale academics (Cremers & Petajisto).

We have seen many studies of investing, but this is the most comprehensive and the most informative in analyzing fund manager skill. It identifies one category of fund managers that do beat their index.

There have been many studies comparing mutual funds to indexes, most of which are actually unfair to both sides:

Unfair to mutual funds:

  1. Include index funds among the mutual funds – 100% of index funds and ETFs underperform their index. They are about 10% of funds. But believe it or not, every study we have seen that shows mutual funds underperform actually include all the index funds among the underperforming mutual funds!
  2. Include “closet indexers” – About 30% of mutual funds try to be similar to the market, since this tends to make investors in those funds comfortable, increases the sales of the fund and tends to preserve the fund manager’s job. Most are trying to be close to the index and are arguably not really trying to beat it. How can you expect to beat the index if you have costs of managing your fund (MER of 2-2.5%) and similar holdings to the index?
  3. Include conservative funds – Many mutual funds don’t even try to beat the index. Because many investors cannot tolerate index level risk, a lot of mutual funds try to be less volatile than the index. For example, of the pure Canadian equity funds, 232 are less volatile than the TSX, while only 76 are more volatile. Leaving a margin for error, 23% of funds (74 funds) are between 10-40% less volatile than the TSX. Are these funds even trying to beat the index?
  4. Include the cost of advice – Most mutual funds pay your financial advisor for comprehensive planning advice (whether you get it or not). With index funds or ETFs, you would have to pay extra if you would benefit from advice or a financial plan. A fair comparison should exclude the cost of advice that is built into the cost of mutual funds.

Unfair to index funds:

  1. Exclude closed funds – Using today’s data has a “survivorship bias” because this excludes funds that closed down. Funds are closed for a variety of reasons, but the most common reason is that the fund was unpopular, so closed funds were more likely underperformers.

I recall a night playing cards with several couples when I realized that all the guys were playing to win, but all the women were really just playing haphazardly and enjoying the company. The game is very different when half the players are not really even trying to win!

That is what the comparison of mutual funds to index funds is like. Depending on what you include, only about 40-60% of mutual funds are actually even trying to beat their index.

Our view is that any study trying to meaningfully measure the skill of fund managers should exclude at least the 40% of equity funds that are index funds or closet indexers, and possibly those that are much more conservative. These studies should only include funds that actually try to beat the index!

Active Share

The Yale study introduced the concept of “Active Share” – the degree to which a fund’s holdings differ from the index. It is a scale from 0-100%, where 0% means it is a passive index fund identical to the index, and 100% means the holdings have no overlap from the index.

They found that among “stock pickers” – funds with an Active Share of 80-100% – the average fund beat the index by 1.5%/year after all fees for the entire 13-year period of the study. Meanwhile, funds with an active share of 0-20% underperformed the index by nearly 1.5%/year.

This is an important point. The conclusion of this very in-depth study was that, once you filter out the index funds and closet indexers, the average mutual fund beat the index by 1.5%/year for 13 years after all fees!

The graph of the results shows clearly a surprising fact – the more different a fund is from the index, the better it tends to perform!


We think that the reason for this is that only a smart, skilled fund manager has the confidence to be completely different from the index.

Looking for funds very different from the index is a great filter to help identify the most skilled fund managers. Those unlikely to outperform will identify themselves by having holdings similar to the index.

Fund managers that are focused on keeping their job by being similar to the index, that have bosses telling them what to do, that make their top 10 holdings look good for investors especially at month-ends (“window dressing”), that want to own popular stocks, and generally are focused on having a fund that people will buy – will want to own companies with big, recognized names. They will want to avoid losing money when others are doing well by having similar holdings and sectors to the index.

We call this the “business of investing”. Fund managers from the “business of investing” will filter themselves out. By focusing on making their fund popular, they will have a low Active Share and little chance to outperform.

However, fund managers that are focused on getting the best possible return with a given risk level, the true, skilled stock pickers that are passionate about researching companies, that are confident in their methods, and that have most or all of their own money in their fund – will want to invest in the undiscovered gems they find and the companies they believe are the most undervalued or the fastest growing.

We call this the “profession of investing”. Fund managers from the “profession of investing” invest like they would invest their own money. By focusing on being the best possible investor, they have the best chance to outperform. The Yale study shows that the average fund in this high Active Share group does outperform – after all fees.

Being very different from the index means there will obviously be times when they will lag while others are doing well, but, and this is the key point – it is necessary to be different from the index if you want to beat it.

In our search to find “All Star Fund Managers”, there are many important factors, but one important criterion is that they must be quite different from the index – which means they will have a high Active Share. It is not easy to identify the truly skilled fund managers, but Active Share is one objective measure that is a good start.


What can we learn from this study?

  1. Be Different – The more different your fund is from the index, the more likely it will outperform.
  2. Avoid “closet indexers” – If the top 10 holdings of your fund include more than 1 or 2 of the top 10 holdings in the index, you may have a closet indexer. You would need to look at the holdings more closely to be sure. With a closet indexer, you are paying the full cost of a skilled fund manager, but you have little chance to outperform. Most closet indexers are from the “business of investing”, which means they are focused on having a fund that will sell, instead of focusing on good performance. Our view is that nobody should buy a closet index fund.
  3. You can get comprehensive advice for free – Even if your fund doesn’t beat the index, but just has similar returns, you may be way ahead. If you would benefit from comprehensive financial advice (and almost everyone would), your mutual funds already pay your advisor. If you own “No advice investments”, such as stocks, ETFs or low cost index funds, you would have to pay extra for advice. If you are paying for advice, you should insist on getting it. Admittedly, the advice from many financial advisors may not be worth paying for, but the #1 reason given by advisors for NOT doing a comprehensive, written financial plan for clients is that “they don’t ask for it”. If you own mutual funds, insist on getting the comprehensive advice you are paying for!
  4. “All-Star Fund Managers” do exist – Most are from the “profession of investing” by focusing on being the best possible investor. They have the confidence in their discipline to be completely different from the index or from currently popular stocks. Active Share gives us one objective measure to help identify them.

You can read the complete study here.

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  You can read his other articles here.

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