For the last decade, financial markets have wandered through unchartered territories. A recession, tightly controlled monetary policy, unstable geopolitical conditions and volatile commodity prices all took aim at the market’s ascension. Despite some temporary drawdowns, the Standard & Poor’s 500 index has traversed a consistent bull run since February 2009.
This continuing upward trend enticed many investors into passive management strategies, or those that seek to mimic the overall market. This exposure, while perhaps advantageous in a continuous bull market, is inherently problematic because it leaves a portfolio with limited potential to outperform its benchmark. And it provides no protection should the market slide into bear territory. With the complexity of today’s markets, now more than ever, it is relevant to be in an active management strategy.
Passive investments, also known as index funds, come in many shapes and sizes. Between exchange-traded funds and index funds, investors poured more than $500 billion dollars into these passive investment vehicles in 2016, according to Morningstar. As a result, many portfolios are weighted toward passive investment strategies.
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But with almost a decade of an upward trajectory on the books, investors must also protect themselves for a possible reversal of this trend. This will most certainly happen at some point. Active share management, which measures the percentage of a portfolio’s holdings that differ from its benchmark, should play an important role in portfolio exposure if for this reason only. Reducing a portfolio’s correlation to the benchmarks provides downside protection while also uncapping the potential for growth.
The case for high active share funds, or funds that invest 80 percent or more of their assets differently from their benchmark, is two-fold. Firstly, a significant amount of academic research concludes that high active share funds outperform. A 2013 study by Antti Petajisto determined that, from 1999 to 2009, high active share funds outperformed both their benchmarks and respective lower-active share funds. And yet, a December 2016 study by Martijn Cremers revealed that out of all assets invested in U.S. equity mutual funds, only 30 percent are in funds with high active share strategies; and, only around 10 percent of assets are in the highest conviction funds, or funds with an active share of 90 percent or higher.
Secondly, high active share funds have the potential to offer similar diversification benefits that are typically associated with passive strategies. The goal of diversification, or spreading risk exposure across securities, is reduced portfolio volatility. Despite some misconceptions, most diversification benefits are realized after relatively few securities are added to a portfolio. In fact, diversification benefits begin to diminish after only 30 stocks in a portfolio. High active share funds provide concentrated diversification benefits that passive investments cannot.
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Data shows that the practice of adding too many securities for diversification purposes actually diminishes risk reduction. A portfolio of only five securities, for example, could be expected to have an annualized volatility of 30 percent or higher. Increasing the holdings to 30 securities, which is within the range of many high active strategies, would result in an expected portfolio volatility around 22 percent. Increasing that to 100 or more holdings would result in a minimal reduction in expected volatility at only approximately 21 percent. In this scenario, the strategy is more likely to track its benchmark and less likely to deliver returns that outperform that benchmark, capping potential growth.
When reviewing these categorized funds, it is important for investors to monitor their manager’s active share. An increasing percentage of mutual fund assets are in strategies with low active share, despite their appearance as active share strategies. These funds charge active management fees for a strategy that simply shadows its benchmark, a practice known as closet indexing. Any portfolio reallocation into active mutual funds must include an evaluation of a fund’s strategy to ensure that it does in fact fall into the higher active share category, so that the portfolio can reap the most benefits from the strategy.
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U.S. equity mutual funds have seen a trending decline in assets in actively managed funds. This downward trend, propelled by assets flocking to passive investment strategies, has put many portfolios at a disadvantage for future growth. Active strategies, particularly those with higher-active share, should not be dismissed, and should be reevaluated for the role they play within a portfolio’s allocation. Now is the time to reevaluate the market’s future and how active strategies fit into that picture.
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Does Your Portfolio Have Enough Active Share Exposure? originally appeared on usnews.com
