In my last article, I introduced the concept of active share and noted its power as a potential screen for selecting high-performing active equity managers. As a reminder, active share is a measure of how active, or different, the manager is as compared to a benchmark or index. The measure is scaled from zero (completely the same as the benchmark) to 100 (completely different than the benchmark). Various studies have demonstrated that high active share managers have, on average, added significant value over benchmark performance both on a before- and after-fee basis (looking backward) and that active share can be used to help select managers who are likely to outperform (looking forward).
If we look at managers through an active share lens, we are able to classify managers into different styles of active management (this type of classification is different than the traditional value/core/growth and large cap/small cap classifications). Further, combining active share with tracking error (discussed in the previous article) allows you to place a manager somewhere on the following spectrum:
Source: Adapted by Proteus Performance Management Inc. from Petajisto (2013)
Under such a classification system, investors can identify if a fund employs a certain style: where sector weightings are close to the reference benchmark but stock weightings are very different (diversified stock picker), where both the sector weighting and stock weighting differ greatly from the benchmark (concentrated stock picker), where the active management of sector weightings and cash levels rather than individual stocks vary from the benchmark (sector picker/market timer), active managers where there is very little difference from the benchmark in terms of stock selection or sector bets (closet indexer) and finally true index funds.
I’d encourage you to try plotting the managers you utilize on this spectrum. Are you surprised in what you find? Does it reconcile with how they say they manage your account?
When you look at active managers through this lens and before fees, the diversified stock pickers performed best, followed by concentrated stock pickers, closet indexers and index funds with sector pickers/market timers performing the worst.
On an after-fee basis, the diversified stock pickers still fared the best, followed by concentrated stock pickers and index funds (these two were very close), then closet indexers and sector pickers/market timers (which both detracted a lot of value after fees).
So if high active share portfolios fared the best and delivered the best results to investors, how prevalent are they in the real world?
The following chart provides the answer and it’s telling:
Source: Adapted by Proteus Performance Management Inc. from Petajisto (2013)
The above chart plots the percentage of assets in the U.S. mutual fund industry, through time, grouped by active share score. The data goes from 1980 to the end of 2009.
The first thing that jumps out in this chart is that there has been a very significant change in how money is managed over the past 30 years—from an environment where more than 95% of assets were managed very actively to an environment where only about 50% are. Also, closet indexers and passive funds were not really on the map in the early 1980s (as far as assets under management are concerned), but now they make up about half of the market.
The growth in passive index investing is a rational response to the fact that average investors will just underperform the market after fees and transaction costs. However, the growth in closet indexers (the managers who project themselves as active and charge active fees but in reality are very benchmark-like) is disappointing. Assets managed by the closet index group has increased from under 2% in 1980 to more than 30% in 2009. In fact, starting in 1995, closet indexing became the fastest growing investment style. In other words, an increasing number of active managers were becoming less and less active over time, all while charging active fees. Furthermore, this block of managers (and, more important, their investors!) were doomed to underperform after fees, with few exceptions.
In other words, the investment business was moving in the exact opposite direction of the Sir John Templeton prescription for outperformance outlined in my last article and repeated here: “If you want to have a better performance than the crowd, you must do things differently from the crowd.”
My next article will explore why this may have evolved in this fashion and what investors can do about it.