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Is your fund manager active enough?

The 'active share' is a useful measure to find out if your fund manager is bravely straying from the benchmark or running little more than a 'closet tracker'.

 

by Michelle McGagh on Oct 30, 2014 at 12:49

Is your fund manager active enough?

Is your active fund little more than a 'closet tracker'? The rise of low-cost passive investing has placed these funds, which charge active management prices but do little to stray from their benchmark, under greater scrutiny.

The cost of 'passive' funds, which track an index such as the FTSE 100, rather than relying on a fund manager to pick stocks they think are going to do well, is falling. You can buy tracker funds or exchange-traded funds that follow US or UK markets with charges as low as 0.07%.

Active funds cost more - typically 0.75% - with investors paying for the expertise of a fund manager they hope will be able to beat the market. But when managers stick too close to an index, investors may question what they are paying for.

Iain Richards, head of governance and responsible investment at Threadneedle, said investors should inspect funds' 'active share' level - a useful measure of how actively a manager is running a fund.

The active share level measures how much the fund's holdings differ from those that make up its benchmark. A portfolio with no holdings in common with its benchmark would have 100% active share, while a fund which held every stock in the benchmark, with the exact same weighting, would have a 0% active share.

‘One issue that is put forward [in the pro-passive argument] is about closet index trackers,’ said. Richards. ‘Investors are paying active fees but getting [a fund manager] who hugs the index. Looking at the active share [level] breaks down the stocks and gives us an insight into the investments.’

He said that investors should be better informed about the active share of a fund as it would enable them to move away from the active versus passive argument, and towards an understanding of whether their investment strategy was adding value.

‘It is not about active versus passive, it is about how to get people to understand what choices are right…to make sure investors have the information they need…[to understand] the costs and what the risk is,’ said Richards.

He added that there was no ‘golden rule’ for what percentage of active share a fund should have but that 50% was a starting level investors could look for.

‘Different people set different benchmarks at different levels,’ he said. ‘A starting level should be 50% but bear in mind that some indices have 2,500 stocks and some have 100; [funds benchmarked against] smaller indices are likely to have lower active share.’

Lifting the lid

Interest in active share has grown in recent years as tracker funds have gained popularity. An academic paper was published in 2009 by Antti Petajisto and Martijn Cremers of the Yale School of Management that analysed the active share of funds.

The report found between 1993 and 2003 funds with active shares of at least 90% outperformed by 1.13 percentage points after fees each year.

However, funds with active share below 60% which were considered ‘closet trackers’ underperformed their index by 1.42 percentage points a year after fees.

Richards said fund managers needed to make the active share of their funds explicit to investors and that Threadneedle planned to publish active shares for its funds. The measure is not generally included on fund factsheets.

Added value

Richards said active share was only one way fund managers could show their worth and pointed to the importance of managers’ ‘stewardship’ role and the need for them to invest money responsibly and even challenge companies over behaviour that threatens investors.

‘We add value above the index…and stewardship is an integral part of management,’ he said. Richards cited Threadneedle's opposition to miner Glencore's (GLEN) takeover of Xstrata as an example.

‘Unlike lots of people who got excited about the headline [merger] we looked through the deal. After the initial fillip it looked like Xstrata shareholders would do well but we were actually going to be a significant loser from the deal,’ he said, ‘[Knowing this] allowed us to step out of the game when the deal went through. That is the reality of active management, we have the ability to make decisions and position clients.’

Richards also pointed to Threadneedle's cutting of its stake in scandal-hit security company G4S (GFS) as the group ‘did not like the way the accounts were being managed to show growth that was not achieved’.

He added that ‘aggressive accounting’ led to ‘aggressive management’ culminating in the company repaying £108.9 million plus tax to the UK government for overcharging, bungling its Olympic bid and receiving a number of fines.

Richards said Threadneedle was starting to gain interest in G4S again after company changes. ‘We were able to take the view that [G4S] was not something we wanted our clients exposed to,’ he said. ‘As [G4S] starts to clean itself up it becomes interesting again. We are trying to understand that dynamic. Although the economic outlook isn’t great now... there is a process [of cleaning up the business] that is starting.’

6 comments so far. Why not have your say?

James Masters

Oct 30, 2014 at 16:21

The whole model needs to change. Rather than taking 0.7% to 1% of the fund value, active managers should take (say) 15-20% of any growth in the fund, and nothing if the value falls. That would then incentivise astute management and reward the expertise investors are paying for. My employer pension fund is currently 'managed' at a charge of 0.7%, but it mindlessly trails the FTSE index and most of its pitiful growth has been eaten up by this unwarranted till-skimming - I would pull it out and put it in a low-cost tracker, but the scheme is rigged to stop me.

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uncommercial

Oct 30, 2014 at 20:09

The trouble with that is the way it incentivises investment in volatile shares so as to gain high fees when going up, and accept nothing on the way back down.

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Greg Kapoustin

Oct 31, 2014 at 02:55

Good point about the complexity of properly aligning incentives. The compensation structure of U.S. hedge fund managers probably contributed to their fondness for high-beta and small-cap shares (http://abwinsights.com/2014/09/18/hedge-fund-crowding-q2-2014/#factor).

A warning regarding Active Share: High Active Share is necessary, but not sufficient, to determine that a fund is active. A closet indexer can have any active share desired. Suppose a fund’s benchmark is S&P500 and it invests all assets in a SPY ETF, or suppose it indexes Russell 2000; both will result in 100% Active Share for a passive portfolio.

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Jayanti Gandhi

Oct 31, 2014 at 10:04

Active fund managers will be out of jobs if charges are based on growth of fund. Stock market does not always go up.see yra 2008 to 2010.

The structure of charges created to keep in jobs at the cost of Invetors. Investors keep them in job in the time of underperformance( Zero or negarive growth)

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Greg Kapoustin

Oct 31, 2014 at 16:04

Good point regarding the complexity of properly aligning incentives. The compensation structure of U.S. hedge fund managers probably contributed to their fondness for high-beta and small-cap shares:http://abwinsights.com/2014/09/18/hedge-fund-crowding-q2-2014/#factor

A warning regarding Active Share: High Active Share is necessary, but not sufficient, to determine that a fund is active. A closet indexer can have any active share it desires. Suppose a fund’s benchmark is S&P500 and it invests all assets in a SPY ETF, or suppose it indexes Russell 2000; both will result in 100% Active Share for a passive portfolio.

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RippedOff

Nov 01, 2014 at 17:33

How does one establish the "active share level" of a fund. Is a manager bound to reply to such a query?

My LAST IFA could answer how active is the Abbey Life Property fund.

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