Active Fund Management is Far From Dead

The wealth management industry seems to be flaunting Newton's Third Law of Physics, "For every action, there is an equal and opposite reaction."


For the past several years the flows of investment assets have flooded into passive mutual funds and ETFs and away from actively managed funds. In 2016 inflows into all passive funds (including ETFs) were $516 billion, while all active funds saw outflows of $326 billion. For the 12 months ended June 2017, passive funds took in 68% of all net new sales into mutual funds, while active funds took in only 32% of the net new sales. This trend began in 2011 and has been growing in proportion ever since. There are many reasons given to justify these asset flows, but ignoring the opposite side of the story could prove detrimental to investors' success.

When working with investors' life savings, the money they are counting on to fund their retirement and financial livelihood, using generalities can be misleading and dangerous. Most of the active vs. passive investing arguments do just that, they assume that all active funds are alike and all passive funds are alike (simply lumping them into broad general categories). In the passive category there are few ways for funds to differentiate themselves from other passive funds tracking the same index. The most common differentiator, by far, is COST. Just last month (effective July 1, 2017), Fidelity Funds lowered their expense ratios on 27 index funds in a direct competitive strike against Vanguard Funds.

On the active fund side of the ledger it is a bit easier for managers to differentiate themselves, although not all of them do. The argument that there are many actively managed mutual funds that are really just "closet indexers" is accurate. In an effort to manage their funds toward a benchmark (read "index"), and minimize their tracking error to that benchmark, there are many actively managed funds that steer their ship too close to their benchmark index thus looking like a number of their competitors and, worse, looking too much like a much less expensive index fund. Yet, there are plenty of active fund managers who effectively differentiate themselves based on their investment philosophy, style, and YES skill.

These differentiated active managers are not always easy to find. They are typically not "stand-alone" funds that you would have as a solo holding in your portfolio. Their deep value/contrarian tilt, or momentum style, or micro-cap orientation make them more appropriate as part of an overall portfolio strategy. It is typically these well-differentiated active managers that share studies showing the long-term benefits of active management, especially the bear market (or downside) protection that active management offers compared to passive funds. Unfortunately, the megaphone being used to distribute this important information is overshadowed by NOISE broadcast by the largest passive fund companies.

So, how do you find these differentiated active managers who have shown consistency in generating stronger long-term results than benchmarks over full market cycles? The best metric to look for is a fund's active share. Active share is a measure of the percentage of stock holdings in a manager's portfolio that differ from the benchmark index. Numerous research studies published over the past 10+ years (from academic institutions and research organizations) have cited the result that funds with high active share are significantly likely to outperform their benchmark. If you simply do a Google search on the topic you will see numerous of these studies from the likes of Yale School of Management, Bernstein Research, and Boston Partners to name three.

Now, to be fair, there are counter-arguments to this active share research (the counter-argument pieces will also appear on the Google search mentioned above - from the likes of Fidelity Funds, AQR Capital, and SEB Investment Management). However, the majority (if not all) of these counter-arguments come directly from index fund providers - not exactly impartial parties to the argument. Many of the facts cited in these counter-arguments for why active share can be misleading are actually driven by metrics generated by index providers to gauge the effectiveness of their own funds. The two most common arguments are: 1) high active share funds have higher tracking error/more volatility relative to their benchmark, and 2) high active share funds often derive much of their outperformance from stocks with market capitalizations different from the benchmark. While both of these arguments are true, they are not reason to toss out active share as a tool to identify strong active managers.

Since tracking error is a benchmark-centric measure, it makes complete sense that a fund with high active share (again, percentage of the fund's stocks NOT in the benchmark) would show more volatility and tracking error relative to that benchmark. The best way to reduce, or eliminate, tracking error is? Create an index fund! So, the more different your portfolio looks compared to a benchmark the more likely it's results will deviate from that benchmark, and Voila! - higher tracking error. The issue of smaller market capitalization stocks is not quite as straightforward, but still a benchmark driven issue. The determination of large, mid, and small capitalization stocks is made by companies such as Standard & Poor's, Russell Investments, and MSCI - all of whom are index providers. These organizations gather data on huge swaths of companies, typically in a common geographic region (i.e., United States, Europe, Canada, etc.). Then, in an effort to create more focused indexes they break these swaths of stocks into market capitalization buckets (they actually break them down into other non-market cap buckets as well - not overly shocking since they can then charge fund managers, publications, and others to use each of those indexes..but I digress).

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So, the index developers parse their indexes into pieces based on the market capitalization ranges of the total pool of companies for which they gather data. These market capitalization indexes are then "sold" to fund managers to be used in return comparisons as mandated by the securities regulatory authorities. And, finally, the index fund providers then use these index-driven market capitalization measures against the active managers who are able to effectively differentiate their funds and generate outperformance related to their active share. Sounds just a bit like the fox's original argument for why he should be put in charge of guarding the hen house! Ask the majority of active fund managers and they will consistently tell you that they do not manage their funds to compare to an index. Instead, as their fund prospectuses state, they are managing toward financial goals - long-term growth of capital, growth of capital and income, growth of income, etc. Last time I checked, there were no indexes - or index funds, for that matter - with similar goals. What is the goal of the Russell 1000 Index? The S&P Mid-Cap 400 Index? I don't think they have anything to do with an investor's goals for their investments or their long-term financial wellbeing.

So, beware Newton's Third Law of Physics. When we experience the next significant market pullback - and we will experience one - what is going to happen to the waves of money flowing into passive index funds and ETFs? How will that effect investors in those funds? And, while past performance is NOT a predictor of future returns, it is highly likely - based on years of academic research - that those funds with the highest active shares will continue to generate benchmark-beating results. To paraphrase the great Mark Twain, the report of Active Management's death is greatly exaggerated.