New York Attorney General Eric Schneiderman recently announced that 13 mutual fund firms, including BlackRock, Vanguard, T. Rowe Price and American Funds, will voluntarily disclose new information about their mutual funds to all retail investors.
The agreement is the culmination of an industry-wide investigation resulting in a New York State Investor Protection Bureau report, “Mutual Fund Fees and Active Share.” The 13 mutual fund firms will begin to disclose Active Share information for each of their actively managed equity mutual funds.
The move to disclose Active Share is a worthwhile addition to the information routinely provided by mutual funds, however, investors should understand the limitations of the Active Share measure before attributing too much importance to it or any other single metric.
Active Share was introduced in a 2009 Yale School of Management paper authored by Martijn Cremers and Antti Petajisto, “How Active is Your Fund Manager?” Active Share measures the percentage of stock holdings in a fund’s portfolio that differs from the fund’s benchmark index. Active Share of zero percent implies that the fund is invested completely the same as the index; 100 percent implies that none of the fund’s holdings overlap with the index. The measure quantifies the degree to which mutual funds deviate from their benchmark index, providing transparency about whether the mutual fund is actively selecting stocks that are either outside the benchmark index or differ materially in weighting from the index.
[See: 10 Investing Themes to Remember for 2018.]
Active Share is an important tool in identifying closet index funds, which are funds that claim to be actively managed and charge higher fees than index funds, but in fact closely track their index in composition and in results. The harm caused by closet indexing is that investors pay more than necessary to achieve a return available at a low cost through index funds or exchange-traded funds.
Although Active Share is a valuable tool in evaluating strategies focused on active stock selection, other investment techniques are commonly employed by mutual funds. Some mutual fund managers are active in rotating among sectors or regions; others have approaches that emphasize style, size, quality or momentum factors. Active Share is a less relevant measure in assessing sector, region or factor-based strategies.
Many funds, including increasingly popular smart beta funds managed by firms such as Dimensional Fund Advisors and AQR, may have low Active Share but provide returns meaningfully different and often superior than the returns of a benchmark index. A low Active Share measure for such funds can understate the degree to which active management is employed.
Active Share may be effective in identifying closet indexers among mutual funds in top-heavy indexes, in which the index is concentrated in a limited number of companies. For example, the top 10 stocks in the Standard & Poor’s 500 index represent approximately 20 percent of the index weighting, and the top 50 stocks represent nearly half the index.
Active Share may be less relevant for indexes that are relatively flat. The Russell 2000 Index, widely used as a benchmark for U.S. small company stocks, has less than 4 percent of the index concentrated in the top 10 index constituents. Approximately 50 percent of the total weight of the Russell 2000 index comes from the top 350 holdings. Given the high cost of implementation for a small company portfolio, closet indexing is far less common in funds that have the Russell 2000 as a benchmark index.
Active Share is typically high for mutual funds benchmarked to flat indexes, while the range of Active Share will vary more widely for mutual funds benchmarked to top-heavy indexes.
[See: 8 Tips to Choosing an Active Fund Manager.]
The 2009 paper from Cremers and Petajisto claimed that mutual funds with high Active Share would outperform those with low Active Share. Subsequent research from Cremers in 2016 challenged the performance conclusions from the 2009 study. The relationship between high Active Share and superior fund performance cited in 2009 may have been attributable to factors beyond stock selection, such as an emphasis on smaller company stocks during dot-com bubble and its aftermath.
A 2014 Fidelity Investment review of Active Share indicated “that a large portion of the average excess return experienced over the past 15 years was due to strong outperformance in the period from 1998 to 2002.” The subsequent research from Cremers identified 2000 to 2001 as providing most of the outperformance noted in the 2009 research study. The Fidelity study also argued that higher levels of Active Share may be associated with greater return dispersion and higher downside risk.
Recent data support the intuitive conclusion that mutual funds with high Active Share are likely to be among the best and worst performers in top-heavy asset classes.
For example, some of the top performers in the U.S. Large Company Core asset class over the past five years have had high Active Share. The Glenmede Large Cap Core Fund (ticker: GTLOX) had an Active Share of 72 percent as of the end of 2016, according to Cremers’ ActiveShare.info website. Another strong performer, Parnassus Endeavor Fund ( PARWX), had an Active Share of 89 percent. Muhlenkamp Fund ( MUHLX) was on the other end of the spectrum despite a high Active Share of 90 percent, with performance near the bottom of its category. The same was true of the First Eagle U.S. Value Fund ( FEVAX), which had an Active Share of 85 percent.
Rupal Bhansali of Ariel Investments has a relevant perspective, pointing out that correct answers are worth nothing in investing if your view is in the consensus. Rewards come from being right when the consensus is wrong, however, there are steep penalties for wrong answers.
No one measure tells all there is to know about a mutual fund — not Active Share, tracking error, information ratio, Morningstar ratings, or expense ratios. Investors who apply a well-designed process incorporating multiple measures are more likely to enjoy long-term success in mutual fund investing.
[See: Warren Buffett’s 8 Favorite Stocks.]
Disclosures: Registration with the SEC should not be construed as an endorsement or an indicator of investment skill, acumen or experience. Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable.
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Active Share Is Easily Misused in Mutual Funds originally appeared on usnews.com
