You have to pity the plight of the active investor as study after study demonstrates the merits of indexing for the average investor. But a recent column in the Globe & Mail by Dan Richards titled “Only the truly active fund managers lead the pack” provided many active investors an opportunity to taunt those in the passive camp. “So, what do you say to that, Mr. Index Investor?” captures the gist of many of the emails I received.
A confession first: I haven’t fully read the paper titled How active is your fund manager? A new measure that predicts performance by Martijn Cremers and Antti Petajisto of Yale University that Mr. Richards refers in his Globe article. Still, it quickly becomes pretty clear that measuring how much a fund manager deviates from the index is not an infallible metric.
First, it is necessary to define one of the metrics the Yale Professors devised to measure how much a fund deviates from the index. They call it “Active Share”, which is simply a measure of how the weightings of stocks in a mutual fund portfolio deviates from the benchmark index. Long-only mutual funds will have an active share between 0 and 100. Index mutual funds whose holdings mirror the weightings in the index have an active share of 0. A mutual fund whose holdings have no overlap with the index have an active share of 100. The authors find that mutual funds with the highest active share outperform their benchmarks by 1.49-1.59% per year after fees and transaction costs.
Unfortunately for proponents of active investing, Active Share does not provide an infallible way to pick mutual funds. To understand why, let’s do a thought experiment. Let’s assume that we have an equal-weighted index composed of just 10 stocks. Let’s further assume that 10 actively-managed mutual funds are available and each fund holds one of the 10 stocks in the index. Each fund has an active share of 90 (just 10% overlap with the index). But it is clear that they can’t all beat the index. In fact, as a group, their performance will trail the index by their average fees.
PS: I have some exciting news to share with you about the new direction the blog will be taking shortly. Later in the day, you’ll notice some changes on the blog (those of you who are reading this through RSS or email will have to click through to find out). Sorry to be mysterious and all but we are working feverishly putting on the finishing touches and we are not quite ready just yet.