Is Your Fund Manager Active Enough?

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In 2004, Antti Petajisto and Martijn Cremers, then colleagues in the finance department at the Yale School of Management, took particular interest in an article in The Wall Street Journal about the Fidelity Magellan Fund. The article called Magellan's manager, then Robert Stansky, a closet indexer because the fund's returns closely tracked those of the Standard & Poor's 500. "I was thinking that made sense, but it could also be that they were just very good at risk management and very well diversified," says Cremers, now a professor of finance at the University of Notre Dame. "To make that distinction, you really have to look under the hood."

"There was so much discussion of closet indexing, but no one was putting numbers to these claims," says Petajisto, who now works in global tactical asset allocation at BlackRock.

With that in mind, Cremers and Petajisto teamed up to find how to differentiate true stockpickers from closet indexers. They finished the first draft of their research in 2006 and in 2009 published a paper, "How Active Is Your Fund Manager? A New Measure That Predicts Performance." That measure -- which they named "active share" -- is the percentage of a fund's weight-adjusted portfolio that differs from its benchmark. Not exactly rocket science. "I'm the first to admit that our measure is very obvious," says Cremers. "I like to think that its simplicity gives it strength."

Indeed, active share is finding its way into the mainstream pretty quickly. The largest fund companies and consultancies now keep close tabs on active share, and both Morningstar and Lipper plan to make the statistic more widely available this year.

If nothing else, active share pulls back the kimono on managers who charge high fees for piggybacking the index. "It gives you a very quick and dirty indication of how active a fund is, relative to the index," says Michael Herbst, director of active-funds research at Morningstar.

Callie Lipkin for Barron's

Martijn Cremers (above) and Antti Petajisto pioneered the concept of active share -- a tool used to evaluate just how active your actively managed fund really is.

It also adds a new wrinkle to the passive-versus-active debate at a time when active managers have, for years, struggled to beat the market. "There is a tendency to paint all active shares with the same brush, but we need to make a distinction between funds that are truly active and funds that are truly not," says Cremers. "Funds with high active share actually do outperform their benchmarks." The 2009 study found that, between 1990 and 2003, funds with active share of at least 90% -- meaning that no more than 10% of their portfolios mimicked the benchmark -- outperformed by 1.13 percentage points after fees. Funds with active share below 60% consistently underperformed by 1.42 percentage points a year, after accounting for fees. The researchers have since independently updated the results, with findings consistent with the initial study.

The study also found that focused funds tend to have high active share, as do funds that invest in small- and mid-sized companies. The size of the fund itself is another factor -- those with more than $1 billion in assets tend to have a tougher time maintaining high active share. As the table shows, the 25 largest mutual funds have fairly middle-of-the-road active-share numbers.

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For all its simplicity, active share still has its caveats and critics. "Unfortunately, there is no real evidence that active share is a predictor of returns," says Larry Swedroe, co-founder and director of research of BAM Advisor Services. He points to some statistical flaws in the study. For example, Cremers and Petajisto cite average excess returns rather than the median; some high-flying funds, Swedroe says, could easily skew the results.

Active share is no crystal ball, but that doesn't take away from its significance, says Terry Dennison, U.S. director of consulting for Mercer Investments. Dog-eared, marked-up, and splattered with coffee stains, the Yale paper has a permanent spot on his desk, where it's "within arm's reach all the time," says Dennison, who has incorporated active share into the firm's analysis of individual fund managers, as well as of entire portfolios. "High active share is no guarantee that a fund will outperform, but it is likely a necessary condition," he says. "You can't beat the index if you look exactly like it."

OF COURSE, SIMPLY BEING DIFFERENT from the index is not enough to beat it -- you need to be different in the right ways. Take Bruce Berkowitz, who runs the Fairholme Fund (ticker: FAIRX), which tops our list of large-company funds with the highest active share. In 2012, Berkowitz's go-anywhere-and-make-big-bets strategy beat 99% of his peers. Over the past three years, however, Fairholme has trailed 99% of its peers.

Fairholme is a highly focused fund; its top 10 holdings make up 86% of its assets. Concentrated funds tend to rank among the highest for active share, but a focused fund isn't necessarily an active fund. "You don't need 500 stocks to look like the S&P 500," explains Dennison. Likewise, seemingly diversified funds can have extremely high active share if they make bold bets or stray from their benchmarks. Fairholme has nearly 100% active share, and 75% of its portfolio is in financials. "The first question I'll ask if a manager touts high active share is, 'Is there a better benchmark you should be using?' " says Morningstar's Herbst.

Among the most active funds, the spread between prior-year winners and losers was 6.81 percentage points per year. Among the least active, the spread was just 1.69 points. Therein lies one of the reasons that managers hug the index. "You have little chance of outperforming, but you won't perform so poorly you'll get fired," says Mercer's Dennison. "What active share does is allow a manager with skill to add value, but with a bad manager it just makes the mistakes bigger."

You might think that the most active funds would come with higher fees, which would eat away at additional returns. That's what Petajisto initially expected, but found it wasn't so. "It turns out the fees are fairly flat," he says.

Traditionally, the industry has relied on tracking error -- a fund's returns relative to a benchmark -- for insight into whether an active manager is earning his fee. But, as Cremers and Petajisto observed, this doesn't tell the whole story, because tracking error reflects stock-picking, market-timing, and, in some cases, pure happenstance. Rather than look at the outcome, the duo instead examined input by comparing weighted fund holdings with benchmark holdings for 2,647 all-equity U.S. funds from 1980 to 2003.

Until 1998, funds weren't required to name a benchmark; now, their self-declared benchmarks are sometimes suspect. (When Barron'sexamined data from Cremers, we found dozens of funds using inappropriate benchmarks -- such as small-company funds comparing their returns with the S&P 500.) As a remedy, Cremers and Petajisto matched funds against 19 different indexes and assigned the index that produced the lowest active share. They found that while active share as a whole decreased over time, relative active share for individual funds stayed consistent.

Most big swings could be explained by changes in management. Fidelity Magellan (FMAGX), for example, had close to 90% active share in the early 1980s under Peter Lynch, but with changes in management and growth in assets, it sank to just 33% in 2000, under Bob Stansky's management. "The fund underperformed, lost assets, Stansky left [in late 2005], and new managers made it an active fund again," says Cremers. Today, Magellan's active share is about 70% versus the Russell 1000.

Even Cremers agrees that high active share isn't a catchall. "I would say, use active share within the fund-selection process, but as one of the many ingredients, including tracking error."

THE STUDY ALSO CONFIRMED what most experts already knew -- that small- and mid-cap funds are less likely to resemble their benchmarks. It's not just the sheer number of companies in small-cap indexes, says Bruce Herring, equity group chief investment officer at Fidelity, but the fact that small-cap indexes tend to be relatively flat, while large-cap indexes tend to be top-heavy. For this reason, he says, large-company managers who want to buy any of the biggest stocks in an index will see their active share tumble. At year-end 2012, Apple (AAPL) was almost 7% of the Russell 1000 Growth index, he notes. "Let's say a large growth manager wants to take a 300-basis-point [three percentage point] active position in Apple," he says. "That's 10% of your fund to get 300 basis points of active share."

Morningstar's director of research, John Rekenthaler, questions whether the Yale researchers' results might be skewed by the relative outperformance of small-cap funds -- which are among the highest-active-share funds -- during that period. Cremers says he and Petajisto took that into account by using benchmark-adjusted returns, as well as by adjusting performance for market, size, value, and momentum. And though the results are not yet published, they also have analyzed funds by stock-market capitalization and found active share to be consistently associated with future performance.

In any case, investors planning to incorporate active share into their own analysis should be careful about taking the number at face value at any given time, warns Jeff Tjornehoj, head of Lipper Americas Research. "It's one of those metrics that needs a lot of context around it," he says.

Although active share does appear to be pretty consistent, there are cases where an otherwise active manager may opt to be more passive as a defensive strategy, he adds. It's also important to look at both active-share and tracking volatility. A fund could have a low active share, but still add alpha, or excess returns, via short positions or sector timing. Conversely, a high-active-share fund could have the same sector exposure as an index and, in turn, behave a lot like that index.

Fidelity tracks active share on all of its funds, says Herring, but "there is no one great measure that captures all the things we think about," he says. And while he does agree that exceptional track records are generally associated with higher active share, funds with moderately low active share can still produce great results, he argues. Case in point: $43 billion Fidelity Growth Company (FDGRX), is up 10.6% a year over the past decade, better than 97% of its large-growth peers and 3.7 percentage points better than the S&P 500. Manager Steve Wymer was a finalist for Morningstar's 2012 manager of the year. Yet, the fund's active share typically hovers between 55% and 65%. "Theoretically, he's on the border [of closet indexer], but he generates incredible returns," says Herring. That's because alpha isn't just a reflection of active share but the kind of active share. Two funds could both have 60% active share, says Herring, but if one is taking an active position in speculative stocks and the other is overweighting blue-chips, the results will be very different.

Even with questions swirling about the methodology and implications of the original Yale study, it has made an impact. Fund companies are not only familiar with the concept, but many are keeping their own stats on active share and, in many cases, touting their high active share when talking with investors. "Managers are now coming forward with their active-share statistics," says Dennison. "They're not waiting for us to come to them."

STEPPING OUT FROM THE BENCHMARK has long been a part of the investing ethos at Janus, says Jonathan Coleman, co–chief investment officer of equities. "The Yale study crystallized it, put a name to it, and articulated it," he says, adding that the firm now monitors active share for all of its portfolios. Fund literature for Artisan Value (ARTLX) talks about the importance of being focused and active. At Fiduciary Management, managers have been talking with investors about active share for years. Managers of the Longleaf Partners fund (LLPFX), which has 97.6% active share, say they have long deviated from the benchmark. "This is, however, a byproduct of our consistent and successful investment approach over almost four decades, rather than an objective which we manage to," says Lee Harper, head of client portfolio management.

When Cremers and Petajisto released their draft in 2006, "We were on top of it pretty quickly," says Sean Kane, a managing director at Cardinal Investment Advisors, which advises $72 billion in client assets and includes active share in its fund analysis. "In a very quantitative world where folks are trying to develop some new sexy measure, this one stands out because it's so straightforward."

In this era of "cheap beta," or market exposure, through indexes and exchange-traded funds, investors are increasingly combining purely passive and purely active strategies, notes Sean Ealy, director of investment manager research at R.V. Kuhns & Associates.

With interest about active share bubbling up and so many questions about the methodology, Vanguard did its own study, which it published in 2012. It looked at the active share, tracking error, and excess return of 903 funds against the Russell benchmarks corresponding with each fund's Morningstar-style box. Vanguard divided that into a five-year evaluation period (2001 to 2005) in which it identified active share, and a six-year performance period in which it examined how those funds performed (2006 to 2011). They found that while the highest-active-share funds beat the lowest-active-share funds to the tune of about six percentage points a year from 2001 through 2005, the difference was negligible over the next six years. Closet indexers -- funds with low active share and low tracking error -- underperformed in both periods.

Cremers and Petajisto chalk up the discrepancy, in part, to timing. Had Vanguard tracked performance over the full 11 years, they say, high-active-share funds would have outperformed.

The studies were consistent in other areas, including the wide dispersion of returns for high-active-share funds. Among these, there were distinct winners and losers, while low-active-share funds generally hovered around their benchmarks. It's important to note that "not everyone wants managers with high active share," says Morningstar's Herbst, explaining that many investors simply seek active managers who can, for example, deliver market returns with less volatility. "Low active share doesn't mean a bad manager or closet indexer, but it does beg the question of whether a manager is charging high fees for index exposure."

Yet, assuming a manager has the talent, says Cremers, why not apply it to the entire portfolio, rather than just half of the fund? "Last time I looked, American Funds Growth Fund of America [AGTHX] had active share below 60%, but over that year, they still beat their benchmark," says Cremers. "You may say, 'So why worry?' What I say is, if you have skill, why not apply that skill to your whole portfolio? And if your fund is too large to do that, why not close your portfolio?"

Meanwhile, he asks, why should investors pay for funds that are "only in the game halfway?" No doubt, adjust expense ratios for the portion of a fund that is truly active, and fees can easily double.

"If you are a closet indexer charging high fees, you are doomed to fail. It's almost impossible to win," Swedroe concedes, adding that "it doesn't take a genius" to come to that conclusion. "But that doesn't mean the odds are good of winning just because you have high active share."

What's more, it's entirely possible to construct a portfolio of very active managers and end up with very low active share. (Many of the funds with low active share that are on this table use a multimanager approach.) "When you start to combine managers, you'll see active share can drop a lot," says Dennison, who says that, for this very reason, the firm now monitors active share across entire portfolios. Imagine a checkerboard, he says, with differently concentrated managers covering different areas. "Put them all together and if managers have independently made choices that cover the entire board," he says "you just bought the world's most expensive index fund."

Our Methodology

To get a snapshot of funds with high and low active share, Barron's asked Morningstar to match active diversified U.S. equity funds against the iShares exchange-traded fund most closely correlated with its Morningstar category. While there is the possibility of tracking error, it's a fitting comparison because the alternative to buying these active funds would likely be an ETF. We also cross-referenced this data with Cremers and Petajisto's results for each fund's self-declared and minimum benchmarks.

We eliminated funds with less than $200 million in assets, screened out alternative strategies, and ditched funds of funds, though it's worth noting that investors should question the wisdom of paying for a fund of funds when the result is essentially an index.

E-mail: editors@barrons.com