No panacea, but use­ful

Stud­ies on ac­tive share strat­egy’s im­pact re­veal no con­sen­sus

Investment Executive - - FOCUS ON PRODUCTS - BY MICHAEL NAIRNE Michael Nairne is pres­i­dent of Tacita Cap­i­tal Inc. of Toronto, a pri­vate fam­ily of­fice and in­vest­ment-coun­selling firm.

ac­tive share — a mea­sure­ment of the de­gree to which an ac­tive port­fo­lio man­ager’s port­fo­lio varies from its bench­mark in­dex — has be­come one of the most pop­u­lar met­rics in the in­vest­ment in­dus­try. “Ac­tive share” is the per­cent­age of a fund’s hold­ings that dif­fers from the fund’s bench­mark in­dex’s hold­ings.

Two pi­o­neer­ing stud­ies pub­lished in 2009 and 2013 found that stock-pick­ing man­agers with the high­est ac­tive share out­per­formed their bench­mark in­dices even af­ter fees and ex­penses. These out­per­form­ers in­cluded con­cen­trated stock-pick­ers who fo­cused on rel­a­tively few stocks as well as di­ver­si­fied stock-pick­ers — port­fo­lio man­agers with high ac­tive share, but broadly di­ver­si­fied port­fo­lios. “Closet in­dex­ers,” whose port­fo­lios had low ac­tive share, un­der­per­formed their bench­marks.

Both stud­ies con­cluded that ac­tive share is sig­nif­i­cantly pre­dic­tive of fund per­for­mance.

How­ever, other stud­ies raise ques­tions about these con­clu­sions. A 2012 study by Penn­syl­va­nia-based Van­guard Group Inc. com­pared the re­turns of a sam­ple of 903 U.S. equity funds clas­si­fied into three cat­e­gories — con­cen­trated stock-pick­ers, di- ver­si­fied stock-pick­ers and closet in­dex­ers — over two time pe­ri­ods: Jan. 1, 2001, to Dec. 31, 2005; and Jan. 1, 2006, to Dec. 31, 2011.

Al­though con­cen­trated stock­pick­ers out­per­formed their bench­marks by 2.96% a year dur­ing the first pe­riod stud­ied, they un­der­per­formed by 0.77% dur­ing the sec­ond pe­riod. Di­ver­si­fied stock-pick­ers eked out a pal­try 0.11% out­per­for­mance per year dur­ing the first pe­riod, but lagged their bench­marks by 0.42% a year in the sec­ond. Closet in­dex­ers were the poor­est per­form­ers in both pe­ri­ods: they un­der­per­formed their bench­marks by 0.67% and 1.22%, re­spec­tively.

Al­though se­lect­ing a high ac­tive share port­fo­lio man­ager doesn’t nec­es­sar­ily lead to out­per­for­mance, pay­ing ac­tive man­age­ment fees for in­dex-like re­turns is a los­ing strat­egy.

A more re­cent study, de­tailed in an ar­ti­cle en­ti­tled “De­ac­ti­vat­ing Ac­tive Share” and pub­lished in the Fi­nan­cial An­a­lyst’s Jour­nal in 2016, uses the same data as the 2009 and 2013 stud­ies, but found there’s no sta­tis­ti­cally sig­nif­i­cant ev­i­dence that funds with high ac­tive share have re­turns that are dif­fer­ent from funds with low ac­tive share. This re­cent study con­cluded that ac­tive share is not a re­li­able pre­dic­tor of per­for­mance.

Morn­ingstar Canada stud­ied the re­la­tion­ship be­tween ac­tive share and per­for­mance in ac­tively man­aged Cana­dian equity funds from Jan. 1, 2001, to Dec. 31, 2015, and con­cluded that “ac­tive share proved a weak and in­con­sis­tent pre­dic­tor of fu­ture re­turns.”

In fact, that study found that ac­tive share ex­plained only about 10% of the vari­abil­ity in ex­cess re­turns among port­fo­lio man­agers be­fore fees and ex­penses. Style ex­po­sure to value, size and mo­men­tum — not stock-pick­ing — were more likely the driv­ers of rel­a­tive per­for­mance.

Worse yet, funds with high ac­tive share tend to charge higher fees, which nu­mer­ous stud­ies have found to be the big­gest de­ter­mi­nant of long-term un­der­per­for­mance.

Con­cep­tu­ally, as in­dex and closet in­dex port­fo­lio man­agers’ re­turns be­fore fees and ex­penses ap­prox­i­mate the over­all mar­ket’s re­turn, you would ex­pect that funds with high ac­tive share will ap­prox­i­mate the mar­ket’s re­turns (be­fore costs). In ef­fect, port­fo­lio man­agers mak­ing win­ning bets would be ex­pected to be off­set by port­fo­lio man­agers mak­ing los­ing bets.

Ac­tive share is not a panacea for se­lect­ing out­per­form­ing ac­tive port­fo­lio man­agers. But, com­bined with a man­age­ment ex­pense anal­y­sis, it’s a use­ful tool for avoid­ing pricey, closet in­dex­ers.

Ac­tive share could help you avoid pricey, “closet in­dex” man­agers

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