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Is “Active Share” the New Phrenology?

Is “Active Share” the New Phrenology?
April 24
00:03 2018

Earlier this month, the New York State Office of Attorney General’s (NYOAG) Investor Protection Bureau issued a report summarizing the findings and outcomes of its investigation into mutual fund fees and disclosures. According to the report, titled “Mutual Fund Fees and Active Share,” “NYOAG analyzed mutual fund fees and disclosures, and surveyed 14 major mutual fund firms in New York and elsewhere for information about their practices.”

The controversial and decidedly partisan report not only took aim at the policies of the current administration, it entered into the passive/active debate by solely targeting actively managed funds. As we’ve seen reported elsewhere (see “A 401k Must Read: Mutual Fund Expense Ratio Myth Busted,” October 9, 2012), some of the most flagrant fee issues occur in passively managed index funds. Worse, the report reveals a rather naïve understanding of mutual funds and investing.

For example, in one of its key findings, NYOAG states “On average, fees on an investment in an actively managed fund cost an investor almost 4.5x more per year than fees on an investment in a passive fund.” While the expense ratios of actively managed funds are generally higher than those of index funds, the fees are not. The expense ratios measure the cost of operating the fund. Actively managed portfolios require experienced professional staff to research, analyze and manage portfolios of stocks. Index funds do not. That accounts for the difference in cost.

Fees, on the other hand, are a function of the fund’s business model. Some business models focus on selling, and some focus on research. The former will usually have fees (e.g., commission loads, 12b-1 fees, and revenue sharing), while the latter may or may not (and when it does, it will generally be in the form of a 12b-1 fee or a revenue sharing fee). These business models can apply to either passive or actively managed funds. Peer-reviewed academic studies show funds that do not have these funds (both passive and active) generally perform better than funds (both passive and active) that do have these fees.

For the most part, though, the Report focuses on the concept of something called “Active Share.” The NYOAG seemed most disturbed by the fact that “all of the firms NYOAG surveyed provide Active Share information to institutional investors, but many of the firms surveyed do not regularly disclose Active Share to retail investors.”

What is active share and why has it become such a buzzword?

“Active Share is the percentage of the fund’s assets that are not invested the same as the index,” says James Schramm, Financial Advisor at Schramm Financial Group in Valencia, California. “For example, Apple, Microsoft, Amazon and Facebook make up roughly 10% of the S&P 500. Does this portfolio manager have more or less than 10% of their fund in these 4 companies and what percentage does his portfolio deviate from the 10%?”

When using Active Share, the higher the number the more active the fund is, the lower the number the more passive the fund is. “Active share refers to the percentage that does NOT mirror the market,” says Clifford L. Caplan, of Neponset Valley Financial Partners in Norwood, Massachusetts. “So, a 70% active share would mean that 70% of the stocks in the portfolio were not in the appropriate index such as the S&P 500 and 30% of the stocks are in the index.”

During the first decade of the new millennium, interest in passive investing fell as actively managed funds regularly outperformed index funds. “The so-called ‘Lost Decade’ was largely the result of the tech meltdown that occurred in 2000,” says Caplan. “As you may recall, the NASDAQ, at the time primarily a tech index, plunged 60%. If you do the math, an investor needs to earn 250% to recover from a 40% decline. Many value managers such as Bill Miller avoided tech stocks and were able to significantly out-perform the market not only in 2000 but for the next several years. In fact, the tech meltdown took 3 years to unwind with the recovery beginning in March 2003. The Lost Decade is further evidence that the investment environment will most often dictate who out-performs: active or passive.”

Since the market bottom of March 2009, this has reversed, and the pendulum began swinging back in favor of index investing. This, in turn, gave rise to greater criticism of active investing in general, and in actively managed funds specifically. “Active Share became a hot topic as more and more research came out that actively managed mutual funds were being outperformed by their indexes after fees,” says Schramm.

Timed perfectly with the market turnaround, Active Share became a buzzword in 2009 with the publication of “How active is your fund manager? A new measure that predicts performance,” by Martijn Cremers and Antti Petajisto, (Review of Financial Studies 22, 3329-3365). The paper was in part a response to active portfolio managers becoming closet indexers to lock in their outperformance through the end of the calendar year (the SEC requires all mutual funds to report performance based on calendar years).

“While bonus arrangements to portfolio managers differ among firms, very often, a portfolio manager would ‘out-perform’ the benchmark index for a few quarters,” says Caplan. “With a bonus within reach, some portfolio managers would then replicate the index for the remainder of the year in order to lock in their bonus. Meanwhile, the shareholder was assessed much higher management fees than they would had they simply bought an index fund like the SPDRs. With such attention being paid to fees and the fact that approximately 80% of mutual fund managers do not out-perform their index, this issue has received much attention. The term ‘Active Share’ arose due to actions by some portfolio managers of mutual funds to mirror the index at times and not provide any ‘alpha’ to investors above and beyond index returns.”

Active Share and Optimal Portfolio Holding Size

One of the primary reasons we see so much closet indexing stems from the fact most mutual funds, because they are so large, contain hundreds of individual stocks. It becomes more difficult to consistently outperform when you’ve got more stocks than the S&P 500. Academic research has identified the danger of this overdiversification for decades. You’d be surprised how few stocks you need to create a diversified portfolio. “There are a lot of studies that consider the optimal amount of stocks to own in a fund to get proper diversification,” says Schramm “but the overall consensus is that 30 individual stocks can get roughly 95% of the benefit of diversification.

Portfolios with fewer stocks tend to have higher Active Shares. “Generally a more concentrated stock portfolio with at least a 70-80% active share is appropriate,” says Caplan. “Often there may be only 30-40 stocks in the portfolio. The risk is that if the portfolio manager is wrong and several positions tank, the returns may under-perform the market. But if the portfolio manager has a long-term track record of accurately assessing opportunities, he can add significant ‘alpha’ to an investors performance. Additionally, in this current investment environment where it appears many stocks are over-valued, top active managers may provide significant excess gains by identifying stocks that are relative bargains. In fact, the evidence is clear that this is occurring in this new investment environment. Of course, it is imperative that an investor identify a top portfolio manager who consistently out-performs the market, and this is easier said than done. Furthermore, some great portfolio managers can have very bad years and investors bail. An example of this is Bill Miller at Legg Mason who out-performed the market for about 16 consecutive years before crashing and burning in 2008. Many investors do not realize that Miller has had a strong comeback the past several years.”

The Fallacy of the NYOAG’s Report

It wasn’t too soon after Cremers and Petajisto’s paper first came out that we began to see the luster of Active Share fade. Several white papers and studies came out critical of the use of Active Share. On such paper was “Deactivating Active Share,” by Andrea Frazzini, Jacques Friedman, and Lukasz Pomorski, (Financial Analysts Journal, March/April 2016, Volume 72 Issue 2). The abstract of this paper concludes “Their findings do not support an emphasis on active share as a manager selection tool or an appropriate guideline for institutional portfolios.”

Even Cremers appears to have had his doubts. He continues to search for better measures. He presented at the Spring 2015 Seminar of The Institute for Quantitative Research in Finance (“The Q-Group”). According to The Q-Group Seminar Summary, “Cremers opened the Q meeting with a surprising finding: funds with high Active Share only outperform when they don’t trade very much. The idea is to look for active managers who take long-term bets away from a passive index.”

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary SolutionsHey! What’s My Number? How to Improve the Odds You Will Retire in Comfort and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on Twitter, Facebook, and LinkedIn.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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