Myth: Higher active share leads to better outcomes
02 January 2019 | Portfolio construction
Commentary by Chris Tidmore, senior investment strategist at Vanguard in the United States.
It's important to address certain investing myths that often trip up investors and financial advisors. For example, one myth is that actively managed investments lead to better outcomes.
The reality is that the zero-sum game and the low-cost advantage apply no matter the percentage of a fund portfolio that differs from a benchmark index.
Active share is a measure of how different a fund is from its benchmark. Some investors believe that active managers should have a high active share. The thinking is that those managers with a high active share are truly active and are more likely to outperform and at a higher level. The extra performance, the reasoning goes, will make their higher fees worth it.
Meanwhile, active managers have long been suspected of being closet indexers, which means their funds closely resemble the benchmarks they measure themselves against. But hugging the index raises the question: Why pay more for active management when you can just buy an index fund?
Does higher active share work?
A lot of people would like you to believe that higher active share leads to greater outperformance versus the benchmark returns. The data, however, do not bear this out. Being different from the market does not get active managers better returns. It gets them different returns—both better and worse. The chart below shows that as active share increases, the range of excess returns increases. Expense ratio has a noticeable effect on this range. As expense ratios increase, a greater proportion of excess returns fall below zero. But what you see is that the cone widens, and then—after costs are taken into consideration—fund performances move below those of their benchmarks.
Higher active share leads to greater dispersion of excess returns
Sources: Vanguard calculations, based on data from Morningstar, Inc., and FactSet.
Notes: We screened the universe of actively managed U.S. equity mutual funds to identify those with inception dates on or before December 31, 2012, selecting for analysis the oldest share class of each fund with available holdings as of that date. We also required that the funds reported annual returns for the five years ended December 31, 2017. These parameters resulted in a pool of 1,547 funds for which we calculated active share. Expense ratios as of December 31, 2012, were divided into quintiles. Returns are displayed as excess returns relative to each fund's reported primary prospectus benchmark for the five-year period ended December 31, 2017.
Why doesn't higher active share work?
To understand why this myth does not hold up under scrutiny, let's first remember that all investing is a zero-sum game, meaning that, in the aggregate, the outperformance by some dollars of investment must equal the underperformance by others.
Across any market, there is a range of returns. Some investors (and active managers) will do better than others, and results tend to follow a bell curve, with investors' returns grouped around the market return, which is the average of all investment dollars. For some investors to obtain a return greater than the market return, others must receive less. An active manager who tilts a portfolio to be dramatically different from the market benchmark may find incredible success, or failure, or the manager may discover portfolio positioning had little overall effect.
But then there is a cost to investing that, as a matter of simple math, must detract from investors' net returns versus the return of the costless market benchmark. Hence, the bell curve will shift to the left (see the figure below). All managers, active and index, face the cost hurdle in any environment. The greater the cost, the greater the hurdle. Active managers who charge a lot may discover they have to take greater risks to justify their fees. Note in particular the red and orange dots in the first chart, which represent funds with expense ratios in the highest 40% of all U.S. equity mutual funds.
Active share can be useful, however, as a means to verify that a fund actually takes the bets it claims to take, whether that is very few or many. By itself, active share may indicate only variation of performance. Higher active share may also lead to higher turnover, and thus higher cost, which is a filter that is correlated with lower performance. A qualitative judgment regarding the health of the investment manager and depth of the analytical team is needed to evaluate active funds. Lastly, patience is necessary, because returns can be inconsistent, even for managers that do outperform over the long term.1
Notes: Costs are represented by fund expense and taxes.
Percentage of actively managed equity funds that outperformed their benchmarks, periods ending December 31, 2016
Sources: Vanguard calculations, using data from Morningstar, Inc.
Notes: Data are as of December 31, 2016. Because of expenses, most index funds also underperform their benchmarks. Our analysis was based on expenses and fund returns for active equity funds available to U.S. investors at the start of each period. The oldest and lowest-cost share class was used to represent a fund when multiple share classes existed. Each fund's performance was compared with that of its prospectus benchmark. Funds that were merged or liquidated were considered underperformers for the purposes of this analysis. The following fund categories were included: small-cap value, small-cap growth, small-cap blend, mid-cap value, mid-cap growth, mid-cap blend, large-cap value, large-cap growth and large-cap blend.
How to succeed with active
Index funds can be a great place to start, but Vanguard believes that actively managed funds can also play an important role in building a diversified portfolio. To succeed with active managers, you need to choose top talent, at a low cost, and then practice patience through the inevitable ups and downs in the financial markets.
1 James J. Rowley Jr., Garrett L. Harbron, and Matthew C. Tufano, 2017. In pursuit of alpha: Evaluating active and passive strategies. Valley Forge, Pa.: The Vanguard Group.
The views expressed in this material are based on the authors' assessment as of the first publication date (November 2018), are subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc. The authors may not necessarily update or supplement their views and opinions whether as a result of new information, changing circumstances, future events or otherwise.
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