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IsYourFundManagerActiveEnough?

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BARRON'SCOVER

IsYourFundManagerActiveEnough?
Ameasurecalled"activeshare"triestodifferentiateactivemanagersfromclosetindexers.
BySAR AH MAX
January14,2013

Tables:TheRealDeals
TheGreatPretenders
In2004,AnttiPetajistoandMartijnCremers,thencolleaguesinthefinancedepartmentattheYaleSchoolofManagement,tookparticularinterestin
anarticleinTheWallStreetJournalabouttheFidelityMagellanFund.ThearticlecalledMagellan'smanager,thenRobertStansky,aclosetindexer
becausethefund'sreturnscloselytrackedthoseoftheStandard&Poor's500."Iwasthinkingthatmadesense,butitcouldalsobethattheywere
justverygoodatriskmanagementandverywelldiversified,"saysCremers,nowaprofessoroffinanceattheUniversityofNotreDame."Tomake
thatdistinction,youreallyhavetolookunderthehood."
"Therewassomuchdiscussionofclosetindexing,butnoonewasputtingnumberstotheseclaims,"saysPetajisto,whonowworksinglobal
tacticalassetallocationatBlackRock.
Withthatinmind,CremersandPetajistoteameduptofindhowtodifferentiatetruestockpickersfromclosetindexers.Theyfinishedthefirstdraftof
theirresearchin2006andin2009publishedapaper,"HowActiveIsYourFundManager?ANewMeasureThatPredictsPerformance."That
measurewhichtheynamed"activeshare"isthepercentageofafund'sweightadjustedportfoliothatdiffersfromitsbenchmark.Notexactly
rocketscience."I'mthefirsttoadmitthatourmeasureisveryobvious,"saysCremers."Iliketothinkthatitssimplicitygivesitstrength."
Indeed,activeshareisfindingitswayintothemainstreamprettyquickly.Thelargestfundcompaniesandconsultanciesnowkeepclosetabson
activeshare,andbothMorningstarandLipperplantomakethestatisticmorewidelyavailablethisyear.
Ifnothingelse,activesharepullsbackthekimonoonmanagerswhochargehighfeesforpiggybackingtheindex."Itgivesyouaveryquickanddirty
indicationofhowactiveafundis,relativetotheindex,"saysMichaelHerbst,directorofactivefundsresearchatMorningstar.
Italsoaddsanewwrinkletothepassiveversusactivedebateatatimewhenactivemanagershave,
foryears,struggledtobeatthemarket."Thereisatendencytopaintallactiveshareswiththesame
brush,butweneedtomakeadistinctionbetweenfundsthataretrulyactiveandfundsthataretruly
not,"saysCremers."Fundswithhighactiveshareactuallydooutperformtheirbenchmarks."The
2009studyfoundthat,between1990and2003,fundswithactiveshareofatleast90%meaningthat
nomorethan10%oftheirportfoliosmimickedthebenchmarkoutperformedby1.13percentage
pointsafterfees.Fundswithactivesharebelow60%consistentlyunderperformedby1.42percentage
pointsayear,afteraccountingforfees.Theresearchershavesinceindependentlyupdatedthe
results,withfindingsconsistentwiththeinitialstudy.
Thestudyalsofoundthatfocusedfundstendtohavehighactiveshare,asdofundsthatinvestin
smallandmidsizedcompanies.Thesizeofthefunditselfisanotherfactorthosewithmorethan$1
billioninassetstendtohaveatoughertimemaintaininghighactiveshare.Asthetableshows,the25
largestmutualfundshavefairlymiddleoftheroadactivesharenumbers.
Forallitssimplicity,activesharestillhasitscaveatsandcritics."Unfortunately,thereisnoreal
evidencethatactiveshareisapredictorofreturns,"saysLarrySwedroe,cofounderanddirectorof
researchofBAMAdvisorServices.Hepointstosomestatisticalflawsinthestudy.Forexample,
CremersandPetajistociteaverageexcessreturnsratherthanthemediansomehighflyingfunds,
Swedroesays,couldeasilyskewtheresults.
MartijnCremers(above)andAnttiPetajistopioneered
theconceptofactiveshareatoolusedtoevaluate
justhowactiveyouractivelymanagedfundreallyis.
CallieLipkinforBarron's

Activeshareisnocrystalball,butthatdoesn'ttakeawayfromitssignificance,saysTerryDennison,
U.S.directorofconsultingforMercerInvestments.Dogeared,markedup,andsplatteredwithcoffee
stains,theYalepaperhasapermanentspotonhisdesk,whereit's"withinarm'sreachallthetime,"
saysDennison,whohasincorporatedactiveshareintothefirm'sanalysisofindividualfundmanagers,aswellasofentireportfolios."Highactive
shareisnoguaranteethatafundwilloutperform,butitislikelyanecessarycondition,"hesays."Youcan'tbeattheindexifyoulookexactlylikeit."
OFCOURSE,SIMPLYBEINGDIFFERENTfromtheindexisnotenoughtobeatityouneedtobedifferentintherightways.TakeBruce
Berkowitz,whorunstheFairholmeFund(ticker:FAIRX),whichtopsourlistoflargecompanyfundswiththehighestactiveshare.In2012,
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Berkowitz'sgoanywhereandmakebigbetsstrategybeat99%ofhispeers.Overthepastthree
years,however,Fairholmehastrailed99%ofitspeers.
Fairholmeisahighlyfocusedfunditstop10holdingsmakeup86%ofitsassets.Concentratedfunds
tendtorankamongthehighestforactiveshare,butafocusedfundisn'tnecessarilyanactivefund.
"Youdon'tneed500stockstolookliketheS&P500,"explainsDennison.Likewise,seemingly
diversifiedfundscanhaveextremelyhighactiveshareiftheymakeboldbetsorstrayfromtheir
benchmarks.Fairholmehasnearly100%activeshare,and75%ofitsportfolioisinfinancials."The
firstquestionI'llaskifamanagertoutshighactiveshareis,'Isthereabetterbenchmarkyoushouldbe
using?'"saysMorningstar'sHerbst.
Amongthemostactivefunds,thespreadbetweenprioryearwinnersandloserswas6.81percentage
pointsperyear.Amongtheleastactive,thespreadwasjust1.69points.Thereinliesoneofthe
reasonsthatmanagershugtheindex."Youhavelittlechanceofoutperforming,butyouwon'tperform
sopoorlyyou'llgetfired,"saysMercer'sDennison."Whatactivesharedoesisallowamanagerwith
skilltoaddvalue,butwithabadmanageritjustmakesthemistakesbigger."
Youmightthinkthatthemostactivefundswouldcomewithhigherfees,whichwouldeatawayatadditionalreturns.That'swhatPetajistoinitially
expected,butfounditwasn'tso."Itturnsoutthefeesarefairlyflat,"hesays.
Traditionally,theindustryhasreliedontrackingerrorafund'sreturnsrelativetoabenchmarkforinsightintowhetheranactivemanageris
earninghisfee.But,asCremersandPetajistoobserved,thisdoesn'ttellthewholestory,becausetrackingerrorreflectsstockpicking,market
timing,and,insomecases,purehappenstance.Ratherthanlookattheoutcome,theduoinsteadexaminedinputbycomparingweightedfund
holdingswithbenchmarkholdingsfor2,647allequityU.S.fundsfrom1980to2003.
Until1998,fundsweren'trequiredtonameabenchmarknow,theirselfdeclaredbenchmarksaresometimessuspect.(WhenBarron'sexamined
datafromCremers,wefounddozensoffundsusinginappropriatebenchmarkssuchassmallcompanyfundscomparingtheirreturnswiththe
S&P500.)Asaremedy,CremersandPetajistomatchedfundsagainst19differentindexesandassignedtheindexthatproducedthelowestactive
share.Theyfoundthatwhileactiveshareasawholedecreasedovertime,relativeactiveshareforindividualfundsstayedconsistent.
Mostbigswingscouldbeexplainedbychangesinmanagement.FidelityMagellan(FMAGX),forexample,hadcloseto90%activeshareintheearly
1980sunderPeterLynch,butwithchangesinmanagementandgrowthinassets,itsanktojust33%in2000,underBobStansky'smanagement.
"Thefundunderperformed,lostassets,Stanskyleft[inlate2005],andnewmanagersmadeitanactivefundagain,"saysCremers.Today,
Magellan'sactiveshareisabout70%versustheRussell1000.
EvenCremersagreesthathighactiveshareisn'tacatchall."Iwouldsay,useactivesharewithinthefundselectionprocess,butasoneofthemany
ingredients,includingtrackingerror."
THESTUDYALSOCONFIRMEDwhatmostexpertsalreadyknewthatsmallandmidcapfundsarelesslikelytoresembletheirbenchmarks.
It'snotjustthesheernumberofcompaniesinsmallcapindexes,saysBruceHerring,equitygroupchiefinvestmentofficeratFidelity,butthefact
thatsmallcapindexestendtoberelativelyflat,whilelargecapindexestendtobetopheavy.Forthisreason,hesays,largecompanymanagers
whowanttobuyanyofthebiggeststocksinanindexwillseetheiractivesharetumble.Atyearend2012,Apple(AAPL)wasalmost7%ofthe
Russell1000Growthindex,henotes."Let'ssayalargegrowthmanagerwantstotakea300basispoint[threepercentagepoint]activepositionin
Apple,"hesays."That's10%ofyourfundtoget300basispointsofactiveshare."
Morningstar'sdirectorofresearch,JohnRekenthaler,questionswhethertheYaleresearchers'resultsmightbeskewedbytherelative
outperformanceofsmallcapfundswhichareamongthehighestactivesharefundsduringthatperiod.CremerssaysheandPetajistotookthat
intoaccountbyusingbenchmarkadjustedreturns,aswellasbyadjustingperformanceformarket,size,value,andmomentum.Andthoughthe
resultsarenotyetpublished,theyalsohaveanalyzedfundsbystockmarketcapitalizationandfoundactivesharetobeconsistentlyassociatedwith
futureperformance.
Inanycase,investorsplanningtoincorporateactiveshareintotheirownanalysisshouldbecarefulabouttakingthenumberatfacevalueatany
giventime,warnsJeffTjornehoj,headofLipperAmericasResearch."It'soneofthosemetricsthatneedsalotofcontextaroundit,"hesays.
Althoughactivesharedoesappeartobeprettyconsistent,therearecaseswhereanotherwiseactivemanagermayopttobemorepassiveasa
defensivestrategy,headds.It'salsoimportanttolookatbothactiveshareandtrackingvolatility.Afundcouldhavealowactiveshare,butstilladd
alpha,orexcessreturns,viashortpositionsorsectortiming.Conversely,ahighactivesharefundcouldhavethesamesectorexposureasan
indexand,inturn,behavealotlikethatindex.
Fidelitytracksactiveshareonallofitsfunds,saysHerring,but"thereisnoonegreatmeasurethatcapturesallthethingswethinkabout,"hesays.
Andwhilehedoesagreethatexceptionaltrackrecordsaregenerallyassociatedwithhigheractiveshare,fundswithmoderatelylowactiveshare
canstillproducegreatresults,heargues.Caseinpoint:$43billionFidelityGrowthCompany(FDGRX),isup10.6%ayearoverthepastdecade,
betterthan97%ofitslargegrowthpeersand3.7percentagepointsbetterthantheS&P500.ManagerSteveWymerwasafinalistforMorningstar's
2012manageroftheyear.Yet,thefund'sactivesharetypicallyhoversbetween55%and65%."Theoretically,he'sontheborder[ofclosetindexer],
buthegeneratesincrediblereturns,"saysHerring.That'sbecausealphaisn'tjustareflectionofactivesharebutthekindofactiveshare.Twofunds
couldbothhave60%activeshare,saysHerring,butifoneistakinganactivepositioninspeculativestocksandtheotherisoverweightingblue
chips,theresultswillbeverydifferent.
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EvenwithquestionsswirlingaboutthemethodologyandimplicationsoftheoriginalYalestudy,ithasmadeanimpact.Fundcompaniesarenotonly
familiarwiththeconcept,butmanyarekeepingtheirownstatsonactiveshareand,inmanycases,toutingtheirhighactivesharewhentalkingwith
investors."Managersarenowcomingforwardwiththeiractivesharestatistics,"saysDennison."They'renotwaitingforustocometothem."
STEPPINGOUTFROMTHEBENCHMARKhaslongbeenapartoftheinvestingethosatJanus,saysJonathanColeman,cochiefinvestment
officerofequities."TheYalestudycrystallizedit,putanametoit,andarticulatedit,"hesays,addingthatthefirmnowmonitorsactiveshareforallof
itsportfolios.FundliteratureforArtisanValue(ARTLX)talksabouttheimportanceofbeingfocusedandactive.AtFiduciaryManagement,managers
havebeentalkingwithinvestorsaboutactiveshareforyears.ManagersoftheLongleafPartnersfund(LLPFX),whichhas97.6%activeshare,say
theyhavelongdeviatedfromthebenchmark."Thisis,however,abyproductofourconsistentandsuccessfulinvestmentapproachoveralmostfour
decades,ratherthananobjectivewhichwemanageto,"saysLeeHarper,headofclientportfoliomanagement.
WhenCremersandPetajistoreleasedtheirdraftin2006,"Wewereontopofitprettyquickly,"saysSeanKane,amanagingdirectoratCardinal
InvestmentAdvisors,whichadvises$72billioninclientassetsandincludesactiveshareinitsfundanalysis."Inaveryquantitativeworldwhere
folksaretryingtodevelopsomenewsexymeasure,thisonestandsoutbecauseit'ssostraightforward."
Inthiseraof"cheapbeta,"ormarketexposure,throughindexesandexchangetradedfunds,investorsareincreasinglycombiningpurelypassive
andpurelyactivestrategies,notesSeanEaly,directorofinvestmentmanagerresearchatR.V.Kuhns&Associates.
Withinterestaboutactivesharebubblingupandsomanyquestionsaboutthemethodology,Vanguarddiditsownstudy,whichitpublishedin2012.
Itlookedattheactiveshare,trackingerror,andexcessreturnof903fundsagainsttheRussellbenchmarkscorrespondingwitheachfund's
Morningstarstylebox.Vanguarddividedthatintoafiveyearevaluationperiod(2001to2005)inwhichitidentifiedactiveshare,andasixyear
performanceperiodinwhichitexaminedhowthosefundsperformed(2006to2011).Theyfoundthatwhilethehighestactivesharefundsbeatthe
lowestactivesharefundstothetuneofaboutsixpercentagepointsayearfrom2001through2005,thedifferencewasnegligibleoverthenextsix
years.Closetindexersfundswithlowactiveshareandlowtrackingerrorunderperformedinbothperiods.
CremersandPetajistochalkupthediscrepancy,inpart,totiming.HadVanguardtrackedperformanceoverthefull11years,theysay,highactive
sharefundswouldhaveoutperformed.
Thestudieswereconsistentinotherareas,includingthewidedispersionofreturnsforhighactivesharefunds.Amongthese,thereweredistinct
winnersandlosers,whilelowactivesharefundsgenerallyhoveredaroundtheirbenchmarks.It'simportanttonotethat"noteveryonewants
managerswithhighactiveshare,"saysMorningstar'sHerbst,explainingthatmanyinvestorssimplyseekactivemanagerswhocan,forexample,
delivermarketreturnswithlessvolatility."Lowactivesharedoesn'tmeanabadmanagerorclosetindexer,butitdoesbegthequestionofwhethera
managerischarginghighfeesforindexexposure."
Yet,assumingamanagerhasthetalent,saysCremers,whynotapplyittotheentireportfolio,ratherthanjusthalfofthefund?"LasttimeIlooked,
AmericanFundsGrowthFundofAmerica[AGTHX]hadactivesharebelow60%,butoverthatyear,theystillbeattheirbenchmark,"saysCremers.
"Youmaysay,'Sowhyworry?'WhatIsayis,ifyouhaveskill,whynotapplythatskilltoyourwholeportfolio?Andifyourfundistoolargetodothat,
whynotcloseyourportfolio?"
Meanwhile,heasks,whyshouldinvestorspayforfundsthatare"onlyinthegamehalfway?"Nodoubt,adjustexpenseratiosfortheportionofafund
thatistrulyactive,andfeescaneasilydouble.
"Ifyouareaclosetindexercharginghighfees,youaredoomedtofail.It'salmostimpossibletowin,"Swedroeconcedes,addingthat"itdoesn'ttake
agenius"tocometothatconclusion."Butthatdoesn'tmeantheoddsaregoodofwinningjustbecauseyouhavehighactiveshare."
What'smore,it'sentirelypossibletoconstructaportfolioofveryactivemanagersandendupwithverylowactiveshare.(Manyofthefundswithlow
activesharethatareonthistableuseamultimanagerapproach.)"Whenyoustarttocombinemanagers,you'llseeactivesharecandropalot,"says
Dennison,whosaysthat,forthisveryreason,thefirmnowmonitorsactiveshareacrossentireportfolios.Imagineacheckerboard,hesays,with
differentlyconcentratedmanagerscoveringdifferentareas."Putthemalltogetherandifmanagershaveindependentlymadechoicesthatcoverthe
entireboard,"hesays"youjustboughttheworld'smostexpensiveindexfund."
OurMethodology
Togetasnapshotoffundswithhighandlowactiveshare,Barron'saskedMorningstartomatchactivediversifiedU.S.equityfundsagainstthe
iSharesexchangetradedfundmostcloselycorrelatedwithitsMorningstarcategory.Whilethereisthepossibilityoftrackingerror,it'safitting
comparisonbecausethealternativetobuyingtheseactivefundswouldlikelybeanETF.WealsocrossreferencedthisdatawithCremersand
Petajisto'sresultsforeachfund'sselfdeclaredandminimumbenchmarks.
Weeliminatedfundswithlessthan$200millioninassets,screenedoutalternativestrategies,andditchedfundsoffunds,thoughit'sworthnoting
thatinvestorsshouldquestionthewisdomofpayingforafundoffundswhentheresultisessentiallyanindex.
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