One of the articles we referenced in a blog post last Summer won the CFA Institute’s Graham & Dodd Award that recognizes outstanding articles published last year. “Active Share and Mutual Fund Performance,” by Antti Petajisto (July/August 2013) which analyzed using Active Share and tracking error in active fund management.
The author unequivically notes that active managers are not all equal: They differ in how active they are and what type of active management they practice. These distinctions allow us to distinguish different types of active managers, which turns out to matter a great deal for investment performance. The author sorted all-equity mutual funds into various categories of active management. The most active stock pickers outperformed their benchmark indices even after fees, whereas closet indexers underperformed. During the period of 1990-2009 one group in particular added value for investors: the most active stock pickers, who beat their benchmarks by 1.26% a year after fees and expenses; before fees, their stock picks beat the benchmarks by 2.61%, displaying a nontrivial amount of skill.
Note that “Factor Bets” are not factors in the sense that we speak of them with Bloodhound, but rather timing and tactical asset allocation.
Summary
Should a mutual fund investor pay for active fund management? Generally, the answer is no. A number of studies have all concluded that the average actively managed fund loses to a low-cost index fund, net of all fees and expenses. However, active managers are not all equal: They differ in how active they are and what type of active management they practice. These distinctions allow us to distinguish different types of active managers, which turns out to matter a great deal for investment performance.
I divided active managers into several categories on the basis of both Active Share, which measures mostly stock selection, and tracking error, which measures mostly exposure to systematic risk. Active stock pickers take large but diversified positions away from the index. Funds that focus on factor bets generate large volatility with respect to the index even with relatively small active positions. Concentrated funds combine very active stock selection with exposure to systematic risk. Closet indexers do not engage much in any type of active management. A large number of funds in the middle are moderately active without a clearly distinctive style.
Focusing on closet indexing, I started by looking at examples of different types of funds and then examined two famous funds in detail. I also investigated general trends in closet indexing over time and the reasons behind them. I then turned to fund performance, testing the performance of each category of funds through December 2009. I separately explored fund performance in the financial crisis of January 2008–December 2009 to see whether historical patterns held up during this highly unusual period. Finally, I tried to identify when market conditions are generally most favorable to active stock pickers.
I found that closet indexing has been increasing in popularity since 2007, currently accounting for about one-third of all mutual fund assets. Over time, the average level of active management is low when volatility is high, particularly in the cross-section of stocks, and also when recent market returns have been low, which also explains the previous peak in closet indexing in 1999–2002.
The average actively managed fund has had weak performance, losing to its benchmark by –0.41%. The performance of closet indexers is predictably poor. They largely just match their benchmark index returns before fees, and so after fees, they lag behind their benchmarks by approximately the amount of their fees. Funds that focus on factor bets have also lost money for their investors. However, one group has added value for investors: the most active stock pickers, who have beaten their benchmarks by 1.26% a year after fees and expenses. Before fees, their stock picks have even beaten the benchmarks by 2.61%, displaying a nontrivial amount of skill. High Active Share is most strongly related to future returns among small-cap funds, but its predictive power within large-cap funds is also both economically and statistically significant.
The financial crisis hit active funds severely in 2008, leading to broad underperformance in 2008 and a strong recovery in 2009. The general patterns were similar to historical averages. The active stock pickers beat their indices over the crisis period by about 1%, whereas the closet indexers continued to underperform.
Cross-sectional dispersion in stock returns positively predicts benchmark-adjusted returns on the most active stock pickers, suggesting that stock-level dispersion can be used to identify market conditions favorable to stock pickers. Other related measures, such as the average correlation with the market index, do not predict returns equally well.
A prime example in the analysis is the history of Fidelity’s Magellan Fund. To this day, Magellan is still famous for its spectacular record under GARP manager Peter Lynch from 1977 to 1990. In his last 10 years as fund manager, Lynch beat the S&P 500 by a stunning 150% leading the path to becoming the largest mutual fund in the U.S. The fund’s subsequent performance, however, was been mixed. During Robert Stansky’s tenure as fund manager from 1996 to 2005, performance was weak and the formerly active fund was suspected of being a closet indexer. Utilizing the Active Share analysis, Magellan did indeed start out as a very active fund under Peter Lynch, with an Active Share over 90%. Yet its Active Share declined as the fund grew. After Stansky took over in June 1996, however, Active Share plunged more than 30 percentage points to 40% in just two years, and it
then kept going down until stabilizing at 33%–35% for the rest of his tenure. This remarkable shift in the fund’s policy represents a conscious decision to become a closet indexer. Not surprisingly, performance suffered during the closet indexing period. The fund lagged behind the S&P 500 by about 1% a year for 10 years.
One of the continuous knocks against active management is consistent underperformance. However, true active management needs to be distinguished from closet index funds that claim active management for a reasonable comparison.