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Academic research suggests that actively managed funds are not worth the effort or higher cost. The marginally higher return is consumed by higher trading fees, management and slippage. The paper, Luck Versus Skill in the Cross Section of Mutual Fund Returns, is just one example of such research that reports such findings around the world. Yet, is all active management the same? Is there a way to separate a certain sub-group of active management that consistently outperforms the market?

Active Management vs Closet Indexing

In the paper, The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees, and Performance, a distinction is made between funds pretending to have active management but are quite similar to an index such as the S&P 500 ETF (NYSEARCA:SPY), and actively managed funds that use targeted stock picking. Before we compare the two classes of active fund investing - is this really a global problem?

Using the definition outlined in the paper that tracks the percentage of portfolio holdings which differ from the benchmark index (called Active Share), and using the suggested 60% threshold as the cut-off for true active management - we get the following figures for 'active funds' that are really closet indexers:

  1. USA - 13% of active funds
  2. Canada - 40% of active funds
  3. France - 63% of active funds
  4. Poland - 81% of active funds
  5. Total Non-US - 38% of active funds
  6. Total (incl. US) - 22% of active funds

Since the US has some of the lowest numbers of closet indexing, should we ignore this? With 2,500 active funds in the US, that means 325 are closet indexers by the papers definition. In addition to that, might we find superior performing funds by choosing among those with extremely high Active Share... say more than 90%? Let's see...

Closet Indexing vs. Active Stock Picking Returns

As a whole, only 45.5% of 'active funds' were able to beat the underlying index when looking at global statistics (according to aforementioned paper). But what happens when we begin to separate funds into categories with relative degrees of closet indexing? Remember that the percentage of Active Share is the amount of difference between fund and index. 0% Active Share is a perfect mirror to the fund and 100% is completely different. The numbers below are represent funds around the world:

  1. Less than 60% Active Share - only 23.5% outperform the market
  2. 60% - 90% Active Share - 42.5% outperform the market
  3. Over 90% Active Share - 60.2% outperform the market

Can we go a step further? By how much do these funds on average under- or out-perform the index?

  1. Less than 60% Active Share - under-perform by 0.13%
  2. 60% - 90% Active Share - outperform by 1.63%
  3. Over 90% Active Share - outperform by 3.64%

A previous paper using similar techniques entitled, How Active Is Your Fund Manager? A New Measure That Predicts Performance, adds a couple other performance boosting measures such as choosing from among smaller funds and among past-years top performers. This gives an average outperformance of 6.5% annually over and above the index benchmark.

An Individual Investor Testing The Theory

Below is my 'individual investor' test of the theory. I selected a high-yielding strategy that picks up a large amount of REITs, MLPs and other high-yielding products.

To create a benchmark of sorts - I take the MLP universe of stocks and restrict it to companies trading at a minimum $5 per share and 50,000 shares daily. This 'index' is rebalanced annually in order to include newer firms. It is equal-weighted. Slippage of 0.5% will represent slippage plus trading costs. Since there is no strategic targeting of stocks, there should be no advantage to more frequent rebalancing other than faster inclusion to our 'index' and higher trading costs might erode value. We will test this theory as well. (Chart compliments of Portfolio123)

(click to enlarge)

  • CAGR (total return) 12.35% (annual rebalancing)
  • CAGR (total return) 12.6% (semi-annual rebalancing)
  • CAGR (total return) 12.3% (quarterly rebalancing)
  • CAGR (total return) 12.34% (4 week rebalancing)

Creating a High Active Share Portfolio

Next, I refine the rules with a couple of comprehensive ranking systems (Portfolio Café - Big Bad Yields). These ranking system look for earnings and revenue growth, debt ratios, and deep value. Furthermore, we will require a minimum of 100,000 shares daily to minimize slippage - although we will keep the 0.5% per transaction. The first test will be use the same annual rebalancing. While we use some strategic timing rules, I will not include market timing that is used in the Portfolio Café model. We stay 100% invested at all times. We only keep the top 15 stocks - which in itself will give us high Active Share. Below is a description of 5 sample picks as of April 1st 2012:

Ticker

Name

Rank

MktCap

Yield

(NYSE:TAL)

TAL International Group, Inc.

84.76

1232.19

5.99

(NYSE:PMT)

PennyMac Mortgage Investment Trust

83.46

561.26

11.78

(NYSE:MAIN)

Main Street Capital Corporation

93.2

657.98

6.82

(NYSE:PAA)

Plains All American Pipeline, L.P.

94.43

12596.62

5.23

(NYSE:CYS)

CYS Investments Inc

83.52

1462

15.28

The chart below shows how this strategy performs with annual re-balancing.

(click to enlarge)

  • CAGR (total return) 12.55% (annual rebalancing)

At first glance it may appear that we are doing no better with our smaller basket of more liquid and strategically targeted stocks. On the other hand, annual re-balancing is likely too long a period between reassessing our stock picks. Despite our strategic rules potentially uncovering highly ranked and quality stocks today, they could drift back into the dull-drums over the next 12 months taking any excess gain with it. While maintaining our 0.5% slippage on all transactions, what will the net result be as we trade more frequently? Will the strategy gain be worth the higher cost of trading?

  • CAGR (total return) 14.47% (semi-annual rebalancing)
  • CAGR (total return) 16.42% (quarterly rebalancing)
  • CAGR (total return) 21.1% (4 week rebalancing)

The returns increase monotonically even after accounting for the compounding slippage. Even if we raised the slippage to 1%, our benchmark-adjusted excess returns with 4 week rebalancing amounts to 5.7% annually or 18.04% total (OTCPK:CAGR). These findings are robust and hold even when we limit our stock selection to the firms within the benchmark universe.

What happens once we include market timing - similar to the model on Portfolio Cafe? In addition to lower portfolio drawdown, the total return rises to 29% annually after accounting for slippage (see chart below)

(click to enlarge)

Active, Closet, and Passive Investing

The lesson learned? If you are re-balancing without an active stock picking strategy (simply putting assets classes back into target weights), you need to carefully weigh any gain against the cost of trading.

On the other hand, if you are rebalancing with a specific strategy in mind and are weeding out low ranking companies to be replaced by quality firms - you stand a higher chance of beating the underlying benchmark. This goes for funds as well - if your active fund looks suspiciously similar to the underlying index, you might want to consider switching funds even if only to an index ETF that has lower management costs.

Alternatively, you can follow the recommendations of the above referenced papers and look for smaller funds that outperformed last year that are substantially different in holdings and relative weighting to the benchmark as you seek to isolate superior fund managers. Or create your own strategic portfolio if you have the time, skill and desire.

This article is a re-print from the Portfolio Cafe blog with approval from the author.

Source: The Truth About Active Vs. Passive Investing