A New Study
Using active fund managers versus indexing has been the source of hot and continuous debate for several years. Two academic studies done in the past two years that support active investing are good reason to review the subject. The first study (2009) done by Yale School of Management”s Martijn Cremers and Antti Petajisto, of New York University’s Stern School of Business, goes by the provocative title: “How Active is Your Fund Manager? A New Measure That Predicts Performance“. The title is in direct conflict with what indexing advocates have said for years: that future performance cannot be predicted. The second study, published in 2010 by Antti Petajisto alone, is titled: “Active Share and Mutual Fund Performance“. The reference to predictive performance is eliminated.
What these studies claim is that investors can find funds that outperform their benchmark after costs, sometimes significantly, by seeking out certain types of active management. The key is to choose those actively-managed funds that contain high “active share” (meaning the percentage of stock holdings in a manager’s portfolio that differ from the benchmark index) and low to moderate tracking error. (Tracking error is the difference between portfolio returns and the returns of a benchmark index.) The author terms these funds “diversified stock pickers.”
The specific results of these two studies also mean that investing in any other type of active funds–concentrated funds, factor bets (market timing and/or sector bets), and closet index funds– will not outperform after costs. So the question then becomes: can individual investors identify funds meeting the criteria, and can they then capture outperformance? To gain some insight into the answer to this question, another non-academic paper by Jensen Investment Management is of interest.
The Significance of the Study Results
Jensen, of course, is promoting The Jensen Fund (28 stocks) as a qualifying fund with high active share and moderate tracking error. But a review of performance shows the Jensen fund has badly underperformed its benchmark in five out of the seven years it has been in existence. And yet, at the same time, it shows a performance ranking among funds of a similar style of a very good 23 percentile ranking for the past five years. How is this possible? There were two good years in the historical performance that influenced the results. In 2006 Jensen outperformed the large growth benchmark by 6.7%, and in 2008 is fell 11% less than the benchmark.
The lesson investors need to take from this is that 3 and 5 year performance records can be heavily influenced by one unusual year. And even 7-10 year performance records can be influenced by one or two unusual years. Investors can be misled by historical performance records and they need to take a close look at what actually happened in the period of interest. And even then, does past performance have any reliable relationship to future performance as the title of the first study claims?
Petajisto clarifies performance predictability as referring to the type of group a fund belongs to (e.g., stock pickers or closet indexers). He also finds some predictability coming from past performance, although that finding is statistically weaker.
When I asked him for more detail on performance predictability, Petajisto replied that the second study had found “the type of group a fund belongs to (e.g., stock pickers or closet indexers) does predict performance. This is naturally consistent with my earlier finding (in the paper coauthored with Cremers) that Active Share in general predicts future performance.”
A few funds with high “active share” mentioned in the Petajisto study show severe underperformance over the past year. FMI Large Cap (27 stocks), for instance, is in the 90th percentile for the past 12 months. Way down from 2009 when it was in the 34th percentile. FMI Large Cap was also in the 71st percentile in 2007. The problem for investors is how to interpret this data.
Petajisto states that there is persistence in performance from one year to the next, but obviously, this is debatable. In fact, a study by Davis Advisors that looked at 160 active fund managers who were top quartile over 10 years showed that for at least one 3 year period within that time 98% were in the bottom half and 43% were bottom decile. The swing in performance may correlate with the number of stocks in a fund. The lower the number, the greater the swing.
Fund Manager Skill vs Investor Skill
When streaks of bad performance are encountered, how does the investor know if it’s going to be temporary or permanent? Gerald Smith, in an article titled, Back to Earth for Active Management states “being right in the long run means being out of step in the short run. In fact, the more active you are, the more likely it is to happen. Periodic underperformance is inevitable and no test of skill.”
Short term fund underperformance may be no test of skill for the fund manager, but it is definitely a test of skill for the investor. Investors are always going to encounter streaks of underperformance, and when considering the Davis study, which observed three year periods of underperformance as not unusual, investors would need to hold for at least four year to determine if a fund has lost its edge, or if the underperformance is due to unfavorable market conditions. Investors cannot expect their fund managers to continuously try to chase the market, and in fact the best managers may tend to stick with their strategy, even when market forces are against them.
Funds with a small number of stocks are going to be the most challenging for investors because of extreme performance swings, so these funds are probably not suitable for inexperienced investors who will have a very difficult time holding through the rough patches.
Successful funds are also sensitive to the amount of assets managed, and those with fewer stock holdings even more so. Funds with a limited number of stocks have a harder time investing new money because the manager can’t find stocks that meet their criteria. Discovery of a good fund will attract more cash and performance is likely to drop.
In contrast to the high active share funds with very few stock holdings, Petajisto’s studies also identified some funds such as T. Rowe Price Small Cap Blend and Fidelity Low priced Stock, which hold a significantly higher number of stocks. Such funds also have bad years, but the number of stocks lessens the swings. They outperform by 30-40% in good years, and underperform by 60-70% in bad years. This might mean funds with a higher number of stocks, while not likely to shoot the lights out, are more stable and more suitable for average investors.
Geoff Considine PhD, a regular contributor to Portfolioist, has reviewed the 2009 paper by Cremers and Pestajisto and he is not convinced. “You can have a high active share simply by diversifying beyond the index against which you are benchmarked,” he emailed. “I remain of the mind that Active Share may simply be capturing funds in which the manager has substantially diversified relative to a benchmark–and you can clearly get some free alpha from doing this. This may be a good thing to do, but it does not mean that managers have skill in stock picking.”
Amanda Kish, CFA, may have the most down-to-earth perspective:
So does this [Cremers & Pestajisto Study] mean you should run out and look for a fund with the highest active share? Not necessarily. Despite the study’s findings, a high active share doesn’t guarantee great performance. In fact, if you think about it, it makes perfect sense that those funds that deviate the most from the benchmark have the greatest chance of beating it. How else can you beat the benchmark, if not by owning different stocks? But it also follows that managers who deviate from the benchmark also have an equal chance of getting their picks wrong, and underperforming. While active share may be one useful tool in identifying decent funds, you should still focus most of your energy on finding funds with a consistent investment process, a management team with a long tenure, and a strong track record.
The Behavioral Factor
One other incidental item of interest in the Jensen paper is a chart that compares outflows of money from large cap active funds vs large cap index funds in the downturn of 2008. Actively managed funds saw an outflow of 120 billion dollar, but the drop in large cap index funds was negligible. This fact is related to behavior and may indicate a much greater willingness by active investors to move in and out of funds on short term movements. Such behavior is regarded as detrimental and it may be encouraged by active funds with very low numbers of stock holdings such as Jensen, FMI, and Sequoia. These funds, while not considered concentrated, are prone to swings from one end of the spectrum (top decile) to the other (bottom decile). Such funds, while meeting the criteria for potential outperformance, will likely create behavioral mistakes for all but the most disciplined investors because of large swings in performance and large tracking error.
The Studies Effect on the Active / Passive Debate
There have been many marathon debates on Morningstar’s discussion boards and elsewhere on which is better, active or passive. These debates seem always triggered by the posting of a study supporting indexing. Such studies seem to rile the emotions of active investors. So, you might think that a study that actually seems to support active investing would be greeted with great cheer and banner waving by the active crowd. But that didn’t happen–the studies were greeted with great indifference. Only a few posters read the study thoroughly enough to comment, and the comments were that the study offered nothing new.
The studies found that about 20% of all tested active funds have outperformed after costs. Investors who use active funds should review the studies carefully, and they must be aware that investing is the manner suggested by Cremers and Pestajisto is not going to be all that easy from the standpoint of identifying the stock picker category and staying with the strategy though thick and thin. Discipline and knowledge are a must.
Inexperienced investors may not fully grasp all the nuances of the strategy or the need to maintain diversification throughout the portfolio. And while finding the successful stock pickers cannot guarantee outperformance, the study’s own conclusion is that investing in any other form of active management but the stock pickers category–factor bets on sectors and timing, concentrated-undiversified funds, and closet indexing–offer no chance of outperformance. Therefore, investors should either choose to index or pursue the high active share stock pickers, which offers the potential of higher returns, but with higher risk related to fund identification, manager mistakes, and behavioral errors that reduce returns.
Will this study finally end the great active / passive debate. No, not a chance.
(photo: Escuela Virtual De Deportes)
A retired chemical engineer, Keck has over the past 11 years become a passionate student of investing, an active contributor to the Bogleheads and Morningstar online investor discussions, and the author of a free online primer to investing, Road Map for Investing Success. He lives in California and when he isn’t thinking about smarter ways to invest, he likes to play golf and bike ride on a regular basis. His last contribution to Portfolioist, The Risk Riddle of Investing, was published November 3.