Image Credit: Christophe Vorlet
By Jason Zweig | Oct. 28, 2016 12:29 pm ET
For fund managers, the days of “If you can’t beat ‘em, join ‘em” might be coming to an end.
For years, many fund managers haven’t done much managing at all. Rather than painstakingly pick what they believe are the best stocks and avoid those they think are the worst, they shadow the market index against which their performance is evaluated. Here and there, they buy a bit more of this stock and a little less of that one, in what’s known as closet indexing.
If a fund has the same 3.4% weight in Apple as the S&P 500, for instance, then that part of it is purely passive. But a fund with 6.8% in Apple — or another that doesn’t own it at all — has a position distinctly different from the index. The greater the proportion of a fund’s assets that deviate from those of the index, the higher its “active share.”
But over time, you can’t beat the market by being the market, plus or minus a smidgen. After fees, often around 1% per year, plus trading costs, closet index funds seldom earn outperformance.
To call such chicken-hearted tweaks “active management” is an insult to the great swashbuckling stock pickers of the past like Peter Lynch of Fidelity Magellan or John Neff of Vanguard Windsor, who bought whatever they thought was cheap regardless of its arbitrary weight in a market index.
Not every fund manager can or should seek to stand out so far from the crowd. But, in a world where you can buy the entire stock market through passive index funds charging annual fees as low as as little as 0.03%, why hire an active manager for 30 times that cost unless he or she will be truly active?
Researchers led by Martijn Cremers of the University of Notre Dame and Antti Petajisto, formerly at Yale and New York universities, have demonstrated that you can think of any mutual fund (or any managed investment, for that matter) as a mix of a passive portfolio tracking the market and an active one trying to beat it.
Isn’t that obvious? Yes and no. Traditional disclosures shed little light on how active a fund truly is. Without access to expensive commercial databases, it hasn’t been easy for individual investors to tell how their managers are trying to outperform.
Now, however, you can view a straightforward measure for most U.S. stock mutual funds at activeshare.info, a website run by Prof. Cremers. A score of 60 is low; 80 and above generally means that a manager is highly active.
Mind you, that alone isn’t a measure of skill. A manager who owns too much of the wrong stocks and not enough of the right ones would have high active share but low returns. And active share isn’t the only way to measure closet indexing — which, to some extent, may be in the eye of the beholder.
Even so, imagine a fund that charges 1% in annual fees but actively manages only 10% of its portfolio. That’s like having 90% of your money in an index fund — which you could hold at close to zero cost — and paying 10% a year to manage the rest.
Among regulators in Europe, closet-index funds are “high on everyone’s agenda,” says Anne Merethe Bellamy, deputy director general of Finanstilsynet, the Norwegian securities authority.
That scrutiny is part of the intense competitive pressures that the rise of passive investing has been placing on actively managed funds that have underperformed for years.
European regulators aren’t seeking to ban closet-index funds or to tell them what fees they can charge. They are urging asset managers to improve disclosures so investors can have a better idea of whether a fund will seek to beat the market or merely hug it.
“There can be an information gap between how the fund is run and what the investor thinks the fund is meant to do,” says Erik Lindholm, deputy director for supervision and consumer protection at Finansinspektionen, the Swedish national securities regulator. The Swedish authority is investigating approximately 25 domestic stock funds to determine the extent to which they may be closet indexing.
With new databases like activeshare, closet indexing might no longer be able to thrive in the shadows in the U.S. That would, at long last, force fund managers to be genuinely active or surrender the market to index funds.
Source: The Wall Street Journal