Thursday 28 Mar 2024
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SINGAPORE (March 16): Fund managers, just like you and me, have different risk appetites. There are the swashbucklers, who sally forth boldly with a few high-conviction bets in pursuit of riches untold. There are those who may play a little safer and maintain a more diversified portfolio. There are also fund managers who, like Hobbits in JRR Tolkien’s The Lord of the Rings, are content to stick closely to their funds’ benchmark index rather than endure the discomforts and risks of adventure.

Almost all fund managers are measured against some kind of benchmark index. To use Japan as an example, many Japan equity funds are measured against an index such as the MSCI Japan, which covers more than 300 large- and mid-cap stocks in the country. Since it accounts for about 85% of the market capitalisation in Japan (based on the MSCI Japan Index factsheet dated January 2017), the MSCI Japan gives a good indication of how Japanese stocks are performing on average.

If we wanted to invest in a diversified portfolio of Japanese equities, we would have two choices. The first is to buy a passive index fund or ETF that holds the same stocks in the same proportions as the MSCI Japan Index. We should then expect our returns to be roughly similar to the market average, minus the usually low costs that index funds would charge for administering the fund.

Alternatively, we could try to beat the index. To do this, we would buy an active Japan equity fund, which hires fund managers to pick Japanese stocks that they think would have the highest chance of appreciating in value. Success is measured by whether the active fund did better or worse than the index after taking into account their management fees, which tend to be higher than for passive funds. For example, based on their January 2017 factsheets, the passive DBX MSCI Japan ETF has a fee of 0.5% a year, whereas an active fund such as the Eastspring Japan Dynamic Fund charges an annual management fee of 1.5% for the retail share class.

Now, what would happen if the active fund manager, after being paid a handsome fee, then decided to invest in a portfolio that was not much different from the MSCI Japan Index? They would be likely to under perform the benchmark index after their management fees are taken into account. The result would not be so bad as to get them fired — they would certainly not do as poorly as the swashbucklers who ventured far from the benchmark and made the wrong bets. But they would have underperformed without much hope of beating the index in the first place. As investors paying them high fees for active manage ment, we would find this unacceptable, and rightly so.

Active fund managers, therefore, need to deviate substantially from the benchmark index to have any hope of beating the index and justifying their higher fees. One way of measuring this is through a metric known as Active Share, which measures the difference between an active manager’s portfolio and the benchmark.

As an illustration of how Active Share is calculated, consider a simple stock market with five stocks, four of which are in the stock index in the proportions shown in Column A. A hypothetical fund manager’s portfolio is in Column B. We can then easily determine that portfolios A and B differ by the difference in each stock’s percentage allocation, as calculated in Column C. The Active Share is then defined as the sum of all the deviations whether positive or negative, divided by two, as calculated in Column D. In this case, the Active Share of the portfolio is 35%.

This definition makes intuitive sense because it expresses the “fraction of the portfolio that is different from the index”, in the words of Martijn Cremers and Antti Petajisto, the two Yale professors who first proposed the measure in 2006. If an active fund has an Active Share of lower than 60%, they suggested, it could be a closet indexer (or what we are colourfully calling a Hobbit in this article) — a fund that charges active management fees but has poor chances of beating the index because its portfolio does not deviate significantly enough.

Closet indexing remains a problem even now, and thus Active Share is something to watch out for when evaluating a mutual fund. Based on an Active Share threshold of 60%, a recent 2016 report by Morningstar estimates that 20% of active funds in Europe remain potential closet indexers. This figure is in line with an updated study on global mutual funds by Cremers and his colleagues in 2015. With increasing industry awareness, more fund managers are starting to disclose their active shares and there is discussion among regulators on whether active shares should be disclosed on fund literature.

Does a high Active Share mean higher-than-average investment returns? Not necessarily — that depends on the quality of the active bets made by the fund manager. But we should avoid funds with a low Active Share because we can usually do better with a low-cost passive index fund.

To that statement must be added two technical caveats. First, there is a class of active funds, known as factor bets, that have low Active Shares but can still deviate significantly in performance from their benchmark. However, studies such as a follow-up paper by Petajisto in 2013 have found that such funds have tended to underperform, even more so than closet indexers, and are thus generally also to be avoided unless one had strong convictions about the investment process of the fund manager.

Second, the 60% threshold for Active Share applies to well-diversified indices with allocations spread out among many stocks (MSCI Europe or Standard & Poor’s 500, for example). For many highly concentrated single-country indices, it is much harder to push Active Share beyond 60% while still remaining within the fund’s mandate. For example, all it would take for Active Share to drop below 60% in Singapore would be for the manager to have at least neutral exposure to the top five stocks in the Straits Times Index, which collectively make up about 40% of the index. In such cases, a 40%-to-50% threshold might make more sense. But even that begs the question: Does it really make sense to pay higher fees for an active manager that has limited room to innovate away from the benchmark?

In any case, the general idea remains: Active Share is useful as part of your fund research to help understand whether you are invested in any closet indexers that are charging you high fees simply for tracking the index. A swashbuckling adventurer may indeed end up as dragon bait, but a Hobbit will never achieve anything for you at all.

Herbert Lian is an independent financial adviser at IPP Financial Advisers. The views expressed here are solely his own. This article should not be regarded as professional in vestment advice or a recommendation regarding any particular investment

 

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