21 active management vs. closet indexers-1
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21 Active Management vs. Closet Indexers-1TRANSCRIPT
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?
March 11, 2013 Active Management vs. Closet Indexers 3
‘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”
March 11, 2013 Active Management vs. Closet Indexers 4
‘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
March 11, 2013 Active Management vs. Closet Indexers 6
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)
March 11, 2013 Active Management vs. Closet Indexers 7
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.
March 11, 2013 Active Management vs. Closet Indexers 8
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
March 11, 2013 Active Management vs. Closet Indexers 9
Passive is becoming more popular…
0%
5%
10%
15%
20%
25%
30%
1980
Q119
81Q1
1982
Q119
83Q1
1984
Q119
85Q1
1986
Q119
87Q1
1988
Q119
89Q1
1990
Q119
91Q1
1992
Q119
93Q1
1994
Q119
95Q1
1996
Q119
97Q1
1998
Q119
99Q1
2000
Q120
01Q1
2002
Q120
03Q1
2004
Q120
05Q1
2006
Q120
07Q1
2008
Q120
09Q1
2010
Q120
11Q1
Perc
enta
ge o
f TNA
in P
assiv
e Fun
ds
Percentage of Total Net Assets in Passive Funds (by cap style) LargeMidSmall
March 11, 2013 Active Management vs. Closet Indexers 10
… as Large-Cap closet indexing is common …
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1984
Q119
84Q4
1985
Q319
86Q2
1987
Q119
87Q4
1988
Q319
89Q2
1990
Q119
90Q4
1991
Q319
92Q2
1993
Q119
93Q4
1994
Q319
95Q2
1996
Q119
96Q4
1997
Q319
98Q2
1999
Q119
99Q4
2000
Q320
01Q2
2002
Q120
02Q4
2003
Q320
04Q2
2005
Q120
05Q4
2006
Q320
07Q2
2008
Q120
08Q4
2009
Q320
10Q2
2011
Q1
Perc
ent o
f Tot
al TN
A in
pas
sive f
unds
% 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%
March 11, 2013 Active Management vs. Closet Indexers 11
… and Small-Cap funds are most active
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1985
Q119
85Q4
1986
Q319
87Q2
1988
Q119
88Q4
1989
Q319
90Q2
1991
Q119
91Q4
1992
Q319
93Q2
1994
Q119
94Q4
1995
Q319
96Q2
1997
Q119
97Q4
1998
Q319
99Q2
2000
Q120
00Q4
2001
Q320
02Q2
2003
Q120
03Q4
2004
Q320
05Q2
2006
Q120
06Q4
2007
Q320
08Q2
2009
Q120
09Q4
2010
Q320
11Q2
Perc
ent o
f Tot
al TN
A in
pas
sive f
unds
% 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%
March 11, 2013 Active Management vs. Closet Indexers 12
Magellan’s Period of Closet Indexing (Active Share each quarter)
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
1981
0619
8203
1982
1219
8309
1984
0619
8503
1985
1219
8609
1987
0619
8803
1988
1219
8909
1990
0619
9103
1991
1219
9209
1993
0619
9403
1995
0619
9603
1996
1219
9709
1998
0619
9903
1999
1220
0009
2001
0620
0203
2002
1220
0309
2004
0620
0503
2005
1220
0609
2007
0620
0803
2008
1220
0909
2010
06
Harry LangeBob StanskyJeff VinikMorris SmithPeter Lynch
March 11, 2013 Active Management vs. Closet Indexers 13
Growth Fund of America’s active bets with stocks inside versus outside its benchmark
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1981
0619
8203
1982
1219
8309
1984
0619
8503
1985
1219
8609
1987
0619
8803
1988
1219
8909
1990
0619
9103
1991
1219
9209
1993
0619
9403
1995
0619
9603
1996
1219
9709
1998
0619
9903
1999
1220
0009
2001
0620
0203
2002
1220
0309
2004
0620
0503
2005
1220
0609
2007
0620
0803
2008
1220
0909
2010
06
Non-Benchmark Stocks Benchmark Stocks
March 11, 2013 Active Management vs. Closet Indexers 14
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
March 11, 2013 Active Management vs. Closet Indexers 15
Descriptive Statistics from 2009 sample (all annualized)
March 11, 2013 Active Management vs. Closet Indexers 16
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
March 11, 2013 Active Management vs. Closet Indexers 18
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
March 11, 2013 Active Management vs. Closet Indexers 19
Low active share
3rd quintile
High active share
-2
-1
0
1
2
3Lo
w tra
ckin
g er
ror
2nd
quin
tile
3rd
quin
tile
4th
quin
tile
High
trac
king
erro
r
Benc
hmar
k-ad
just
ed re
turn
(%)
Concentrated stock pickers
Closet Index
Diversified stock
pickers
Factor bets
March 11, 2013 Active Management vs. Closet Indexers 20
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%
-2%
-2%
-1%
-1%
0%
1%
1%
2%
2%
3%
3%
1 2 3 4 5
Perfo
rman
ce p
er ye
ar
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)
March 11, 2013 Active Management vs. Closet Indexers 21
Basic Results: Independently Replicated by Morningstar
March 11, 2013 Active Management vs. Closet Indexers 22
Interpretation: What do you need to outperform?
3 Necessities 1. Skill
2. Conviction
3. Opportunity
Relation to Active Share
March 11, 2013 Active Management vs. Closet Indexers 23
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
March 11, 2013 Active Management vs. Closet Indexers 24
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
March 11, 2013 Active Management vs. Closet Indexers 25
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
March 11, 2013 Active Management vs. Closet Indexers 26
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Graveyard
March 11, 2013 Active Management vs. Closet Indexers 30
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!
March 11, 2013 Active Management vs. Closet Indexers 31
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
rman
ce p
er ye
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)
March 11, 2013 Active Management vs. Closet Indexers 32
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
March 11, 2013 Active Management vs. Closet Indexers 33
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:
March 11, 2013 Active Management vs. Closet Indexers 34
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
March 11, 2013 Active Management vs. Closet Indexers 35
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
March 11, 2013 Active Management vs. Closet Indexers 36
… Mid-Cap funds are more active …
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1986
Q119
86Q4
1987
Q319
88Q2
1989
Q119
89Q4
1990
Q319
91Q2
1992
Q119
92Q4
1993
Q319
94Q2
1995
Q119
95Q4
1996
Q319
97Q2
1998
Q119
98Q4
1999
Q320
00Q2
2001
Q120
01Q4
2002
Q320
03Q2
2004
Q120
04Q4
2005
Q320
06Q2
2007
Q120
07Q4
2008
Q320
09Q2
2010
Q120
10Q4
2011
Q3
Perc
ent o
f Tot
al TN
A in
pas
sive f
unds
% TNA in Active Share deciles of Mid-Cap Active Funds
90%-100%80%-90%70%-80%60%-70%50%-60%40%-50%30%-40%20%-30%10%-20%0-10%
March 11, 2013 Active Management vs. Closet Indexers 37
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 Mid-Cap Funds
March 11, 2013 Active Management vs. Closet Indexers 38
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
March 11, 2013 Active Management vs. Closet Indexers 39