21 Active Management vs. Closet Indexers-1

Active Management vs. Closet Indexers Martijn Cremers, Ph.D., Professor of Finance, Mendoza College of Business; University of Notre Dame Jess Gaspar, Ph.D., Managing Director, Head of Quantitative Research, Commonfund

March 11, 2013

Topic 1 (of 2) Academic evidence What does “Active” mean?

• Active Share: difference in holdings • Tracking error volatility: difference in returns

How active are funds? • Fees of active versus passive funds

Do actively managed funds outperform? • Net returns (after all expenses except loads)

March 11, 2013 Active Management vs. Closet Indexers 2

Topic 2 (of 2) What does that mean for mutual fund investors? Monitor your funds’ Active Share

• Consistent with profile and fees? • Relative to other funds with same benchmark, expenses, size, etc.,

understand active bets taken How to interpret Active Share?

• What does a manager need to outperform? Skill, Conviction and Opportunity

• What does Active Share say about each of those?


‘Active’ means ‘Different’ How to distinguish truly active funds from closet index funds: Decompose portfolio into two parts:

Traditional metric: ‘tracking error (volatility)’ or “return differences”


‘New Metric’ based on ‘active’ portfolio holdings Compare portfolios weights: fund versus its benchmark

Size of the active positions as a fraction of the entire portfolio Proportion of portfolio that is different from its benchmark Treat ‘underweighting’ and ‘overweighting’ identically Between 0 and 100% for mutual funds Easy to compute, but hard to “game”

Persistent over time for typical fund March 11, 2013 Active Management vs. Closet Indexers 5

Cremers & Petajisto, 2009, “How active is your fund manager?”, RFS

Active Share

𝑨𝑨𝑨𝑨𝑨𝑨 𝑺𝑺𝑺𝑺𝑨 = 𝟏𝟐� 𝒘𝒇𝒇𝒇𝒇,𝑨 − 𝒘𝒃𝑨𝒇𝑨𝑺𝒃𝑺𝑺𝒃,𝑨

𝑵

𝑨=𝟏

Active Share, Tracking Error and Passive Management


Figure 1 Different types of active and passive management Active Share represents the fraction of portfolio holdings that differ from the benchmark index, thus emphasizing the stock selection. Tracking error is the volatility of fund return in excess of the benchmark, so it emphasizes bets on systematic risk.

From Cremers-Petajisto, 2009

Active Management Types: (Examples from 2009)


What level of Active Share is reasonable? How many people can be above average drivers? What percentage of benchmark assets can beat the benchmark?

Logic: exactly half the holdings will beat the portfolio’s return

… thus a truly active fund has an Active Share (clearly) above 50%

“Closet Indexer” = Active Share below 60%

• At least 40% portfolio holdings overlap with benchmark

Benchmark-specific: example for S&P 500 benchmark Choose 100 random stocks from S&P 500, value-weight Result: Active Share of about 80% Choose 100 random stocks from Russell 2000: Active Share of 95% Benchmark concentration / # of stocks / liquidity / etc.


Beyond the ‘active-passive’ debate It’s not (just) about active-passive

It’s about paying for TRULY active Explicit indexing: index funds and ETFs

Closet Indexing: funds claiming to be active but whose holdings are ‘similar’ to their benchmark, or with a low Active Share

Active management: funds that are truly active in terms of distance from benchmark holdings, or with a high Active Share


Passive is becoming more popular…

0%

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Perc

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Percentage of Total Net Assets in Passive Funds (by cap style) LargeMidSmall


… as Large-Cap closet indexing is common …

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% Total Net Assets in Active Share deciles of Large-Cap Active Funds

90%-100%80%-90%70%-80%60%-70%50%-60%40%-50%30%-40%20%-30%10%-20%0-10%


… and Small-Cap funds are most active

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% Total Net Assets in Active Share deciles of Small-Cap Active Funds

90%-100%80%-90%70%-80%60%-70%50%-60%40%-50%30%-40%20%-30%10%-20%0-10%


Magellan’s Period of Closet Indexing (Active Share each quarter)

0%

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1981

0619

8203

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8309

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8503

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8609

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8803

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8909

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1219

9209

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9403

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0619

9603

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1219

9709

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06

Harry LangeBob StanskyJeff VinikMorris SmithPeter Lynch


Growth Fund of America’s active bets with stocks inside versus outside its benchmark

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Non-Benchmark Stocks Benchmark Stocks


101 102 103 104 1050

20

40

60

80

100

Fund size ($M)

Act

ive

Sha

re (%

)

AverageMarginal

Funds with over $10 Billion TNA

Funds with over $1 billion TNA

Fund Size and Active Management Large-Cap Funds


Descriptive Statistics from 2009 sample (all annualized)


1.4%

1.2%

1.0%

0.0% 0.5% 1.0% 1.5%

High ActiveShare (Top

Quintile)

Moderatelyactive

Closet Index(Active Share <

60%)

Expenses

10.0%

6.2%

3.8%

0.0% 5.0% 10.0%

Tracking Error

64%

73%

91%

0% 50% 100%

Turnover

Active Share and Total Expenses

0%

1%

1%

2%

2%

3%

3%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Tota

l Ann

ual E

xpen

ses (

=Exp

ense

Rat

io +

Fron

t Loa

d / 5

Active Share

Active Share & Expenses for Large Cap Funds (2010:Q1)

Funds that are not relatively expensive Funds that have high rescaled expenses (>2.10%)March 11, 2013 Active Management vs. Closet Indexers 17

Bottom line: Do active managers outperform? Academic evidence regarding the value of active management in mutual funds

Mostly against Sharpe (1966), Jensen (1968), … , Gruber (1996), French (2008),

Fama and French (2010), and many others

Few for Grinblatt and Titman (1989, 1993), Kacperzyck, Sialm and Zheng

(2008), Cremers and Petajisto (2009), and a few others Argue that some funds outperform


1.20%

-0.60%

-0.89%

1.37%

-0.95% -1.00% -1%

0%

1%

High Active Share(Top Quintile)

Moderately active Closet Index(Active Share < 60%)

Benchmark-Adjusted Annual Return

Risk-Adjusted Annual Return

Net annualized returns after all costs except loads, 1990 - 2009

High Active Share funds outperform Low Active Share funds underperform


Low active share

3rd quintile

High active share

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-1

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High

trac

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erro

r

Benc

hmar

k-ad

just

ed re

turn

(%)

Concentrated stock pickers

Closet Index

Diversified stock

pickers

Factor bets


Benchmark-adjusted returns (net of fees), 1990-2009

Benchmark-adjusted Net Performance in Active Share – Tracking Error double sort

0.00% 0.08%

1.00%

1.87%

2.70%

-0.96% -1.10% -1.07% -0.91%

-0.44%

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-1%

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PRIOR YEAR RETURN Quintile

Stock Pickers (highest 20% Active Share)

Closet Indexers

Greater Performance Persistence for Active Funds Excess Net Returns (relative to benchmark, after expenses)


Basic Results: Independently Replicated by Morningstar


Interpretation: What do you need to outperform?

3 Necessities 1. Skill

2. Conviction

3. Opportunity

Relation to Active Share


1. ‘Stock Picking’ skill High Active Share ‘Factor Bets’ skill High tracking error

2. Lack of conviction or Benchmark hugging fear of underperformance

Guts More concentrated portfolios

3. Limited universe or Limit Active Share tracking error constraints Position limits Diversification

Interpretation: Active Share and Performance Closet Index Funds Similar holdings to benchmarks Expected to underperform benchmarks

Most Active Funds Very different holdings: Strong conviction + opportunity No skill needed for high Active Share Active Share could measure skill if competitive environment allows

only most skillful managers to survive with a truly active portfolio How long can one survive with lots of guts & opportunity…. … but (say) no skill?

Skill should attract inflows harder to outperform with a larger fund


How can one use Active Share? How active is your fund manager? With stocks inside / outside benchmark, tracking error vs. Active Share Are you paying for active management?

Determine the type of active management Stock picking versus factor bets

• Better understand strategy / risk / exposures in terms of size of active bets Skill / guts / opportunity

Active Share predicts mutual fund returns High Active Share funds have outperformed

• Especially with good track record and not ‘too big’ Low Active Share funds tend to underperform


More info “How Active is Your Fund Manager? A New Measure That Predicts

Performance” Introduces Active Share, U.S. sample results, published http://papers.ssrn.com/sol3/papers.cfm?abstract_id=891719

“The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees, and Performance”

International sample, over 30 countries, working paper http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1830207


http://papers.ssrn.com/sol3/papers.cfm?abstract_id=891719

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1830207

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Graveyard


But: the fund market speaks for itself What percentage of mutual fund assets worldwide is managed

passively through index funds or exchange-traded funds?

20%

Outside the U.S. the total is 14%

In the U.S. the total is 24%

86% is actively managed!

76% is actively managed!


1.43%

1.03% 1.12%

1.87%

0.53%

-0.81% -0.98% -0.86% -0.84% -0.98%

-2%

-2%

-1%

-1%

0%

1%

1%

2%

2%

1 2 3 4 5

Perfo

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ar

FUND SIZE Quintile

Stock Pickers (highest 20% Active Share) Closet Indexers

Similar Performance Across Size Quintiles (except maybe very largest funds) Excess Net Returns (relative to benchmark, after expenses)


Summary Active Share New measure of active management How different are the holdings? Use together with tracking error volatility

Active Share predicts mutual fund returns High Active Share funds tend to outperform benchmarks Especially with good track record and not ‘too big’

Low Active Share funds tend to underperform Underperform their benchmarks due to higher costs

Skill / Conviction / Opportunity


Tracking Error (Volatility) Consider the same portfolio decomposition:

Expressed in terms of returns:

Tracking error is defined as the standard deviation of the active return:


Stock pickers

Concentrated

Factor bets

Moderately active

Closet indexers

Active Share Tracking Error Quintile Quintile Low 2 3 4 High Group Label

High

4

3

2

Low

Five Categories of Active Management


What is the problem with low Active Share? Nothing, if you are an enhanced index fund With relatively low fees

What about a fund advertising as an active fund? Passive part of the portfolio Easily replicated by low-cost passive fund Charging active fees for passive management? Fund expected to underperform Fees not reflective of investment service promised Rescale expenses as if fund would have 100% Active Share

Rescaled Expenses = 𝑬𝑬𝑬𝑨𝒇𝑬𝑨𝑬 − 𝟏𝟏𝟏𝟏−𝑨𝑨𝑨𝑨𝑨𝑨 𝑺𝑺𝑺𝑺𝑨 𝑬 𝑷𝑺𝑬𝑬𝑨𝑨𝑨 𝑬𝑬𝑬𝑨𝒇𝑬𝑨𝑬𝑨𝑨𝑨𝑨𝑨𝑨 𝑺𝑺𝑺𝑺𝑨


… Mid-Cap funds are more active …

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AverageMarginal

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Funds with over $1 billion TNA

Fund Size and Active Management Mid-Cap Funds


Group Label # funds % lg-cap % sm-cap Expenses Turnover T.E. Active Share

Stock pickers 197 27% 56% 1.36% 64% 10.0% 96%

Concentrated 49 33% 59% 1.42% 53% 16.5% 98%

Factor bets 196 76% 16% 1.18% 69% 10.4% 77%

Moderately active 590 57% 20% 1.17% 73% 6.2% 81%

Closet indexers 196 88% 5% 1.00% 91% 3.8% 57%

Descriptive Statistics from 2009 sample


21 Active Management vs. Closet Indexers-1

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