Actually Active

9 Oct 2017

 

The job of an active manager is to select investments with the aim of outperforming the fund’s stated benchmark or index.  Together with fund analysts, the portfolio managers will actively research, buy, hold and sell stocks to achieve this.

Active managers need to be highly differentiated to justify the active fees – either through outstanding performance or demonstrating low correlation between underlying portfolio assets.

In recent years many critics have claimed that active managers are in fact closet trackers and we would agree that many managers are masquerading as active fund managers when in reality they are closet trackers.  In the current investment landscape how can “actually active” managers be distinguished from index-hugging strategies charging active management fees?  We have also noted that this debate isn’t just about the benefits of active vs passive, but whether it makes sense for an investor to pay higher fees for active management.

“Active share” is a helpful metric to begin to distinguish between genuinely active managers and closet trackers.  The concept of active share has been defined by two academics, Martijn Cremers and Antti Petajisto, as “the fraction of the portfolio that is different from the benchmark index”.   Active share is calculated by taking the sum of the absolute value of the difference between the weighting of each holding in the portfolio and the weight of each holding in the benchmark index and dividing by two.  Following these calculations, an index fund would have an active share of zero, whilst a fund without any benchmark holdings would have an active share of 100%.

This calculation, whilst crude, has produced data showing a strong correlation between high active share and outperformance to the extent that some mandates are now stipulating minimum active share values for funds.  However, high active share alone does not guarantee outperformance; the manager’s stock selection is crucial and the overweights must be in the outperforming stocks.

By paying slightly higher fees an investor can access an active fund which takes qualitative considerations into account and a more nimble fund which can react to changing markets and fundamentals in a way which tracker funds can’t.  For example, in market climates when there are rising rates, investors are better off in an active fund with the flexibility to reduce interest-rate sensitivity as ETF’s are unable to change their portfolios to reflect these rates as they are obligated to replicate index performance by owning the same securities as the index.

Many advisers therefore feel that investing in an actively managed fund with a strong long-term track record and which charges lower management fees than its peers can be highly beneficial to investors.

Actually active - that’s the CRUX.

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