Starting around 20 years ago, low-fat diets became the craze among people trying to lose weight and live healthier lifestyles. The basic mantra was to eat less fatty food and increase activity levels. However, in recent years, studies in -nutrition have laid waste to this belief as it has become evident that not all fats are the same.
Now we know that saturated fats and trans fatty acids (a.k.a. trans fats) are the ones that should be avoided as much as possible. These “bad” fats can raise cholesterol, clog arteries, and increase the risk of heart disease. Unsaturated fats, on the other hand, are actually good for you in moderation, helping to lower cholesterol levels and reduce the risk of heart disease. Although they can all be categorized as fats, saturated and unsaturated fats affect your health in completely different ways.
Active vs. Passive Investing
Much has been made over the years about active investment strategies/managers having difficulty outperforming passive investment strategies net of fees over long periods of time. For a quick definition in case you are unfamiliar with the terms, active managers seek to outperform the market via stock selection and -asset allocation decisions whereas passive managers simply accept the market return by duplicating market indices like the S&P 500 or Dow Jones Industrial Average. To the credit of the passive camp, many studies have confirmed that the majority of active managers fail to outperform their benchmark index over time.
Not All Active Managers Are the Same
New thinking in the financial community suggests that active managers may be being painted with too broad a brush. In 2009, Martijn Cremers of Notre Dame and Antti Petjisto of Yale, published a research paper entitled, “How Active is Your Fund Manager? A New Measure That Predicts Performance”. The measure referenced in the title, which they called “active share”, is the percentage of a fund’s holdings that differs from the holdings of its benchmark index. The higher the percentage, the more actively-managed a fund is. For example, a mutual fund with an active share of 80% means that 80% of its assets are different from those of its benchmark index while the remaining 20% closely track the index.
The most interesting finding in their study was that funds with a high active share fared much better relative to their benchmarks than funds with a low active share. According to the study, between 1990 and 2003, funds with an active share of at least 90% outperformed their benchmark by 1.13% per year net of fees. During the same timeframe, funds with an active share below 60% underperformed their benchmark by 1.42% per year net of fees.
The reason for the performance differential is simple. Funds with a low active share closely track their benchmark index. Despite claiming to run an active investment strategy, they are “closet index funds” as we like to say in our industry. But because these closet index funds charge higher fees typically associated with active management, they have a hard time making up for those fees with outperformance. For example, if an active fund closely tracks the S&P 500 Index but charges a 1% management fee for their “expertise”, the fund will likely underperform by about 1% per year because of those fees and a market-like expected return. An investor in that case would be better served just buying a passive index fund that charges fees that are typically 80% to 90% less.
Conclusion
While the debate between active and passive strategies is hardly over, the concept of active share provides new food for thought. It is clear that not all actively-managed funds are truly active, so it will be important to attempt to properly measure the performance of true active managers relative to their benchmark indices in this ongoing debate. Lumping together true stock pickers and asset allocators along with closet index funds will certainly lead to misleading comparisons between active and passive strategies.