Active, passive and statistics

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Active managers have again been criticised for their performance, but Simon Clinch, US Equities Fund Manager at Invesco Perpetual, believes the data referenced includes the performance of passive managers and closet indexers as well.

Homer Simpson once said: “You can come up with statistics to prove anything… Forty percent of all people know that”. This is a hilarious quote (at least I think so), but sadly it is also an interesting parody of how data is often presented to the public.

An edition of The Economist earlier this month included an article under the “Buttonwood” column (Practice Makes Imperfect, 9 August 2014) that reiterated the widely held view that active US equity managers, in aggregate, fail to beat the market on a consistent basis, referencing studies from sources such as the Financial Analysts Journal and Vanguard, a US investment company noted for its exchange traded funds.

As a believer in the benefits of active management in US equities, it is hard not to take these articles personally. But after digging a little deeper, it doesn’t take long to uncover a common flaw in the data analysis that is conveniently glossed over.

Active Share’ is an important phrase for the fund management industry that emerged from an excellent 2006 paper by Martijn Cremers and Antti Petajisto: “Howactive is your fund manager? A new measure that predicts performance” (Yale School of Management).

Active Share is a measure of just how active a fund is, a figure representing how much of the portfolio is different to the benchmark. In his follow-up 2010 paper, Petajisto drew upon Cremers and Petajisto (2009) to set the closet-indexer cut-off at an Active Share of 60%.

Petajisto’s research shows that, over the long-term, managers of US equity mutual funds with the highest Active Share outperform their benchmark indices even after fees and transaction costs, in contrast to underperformance by those with the lowest Active Share ratios (1 January 1990 – 31 December 2009).

The problem with the research referenced by the Buttonwood column is that it is based on datasets covering a broad universe of US equity mutual funds, as is much of the commonly-read material available on this subject. But are these samples true representations of active portfolio managers?

I write this from the perspective of an active manager with a current Active Share ratio of more than 87%. To put this in perspective, out of 397 US equity mutual funds benchmarked against the S&P 500, the average ActiveShare is 78.7%.

We believe that truly active managers should have an Active Share ratio of above 80% at the very least, and on this basis 188 of the funds in this group are “passive” or “closet indexers”. That means fewer than half of the funds can be considered truly active, in our opinion.

Furthermore, if we look at the average annualised gross performance figures for the periods in Table 1 and 2 (performance figures are gross of fees, in USD, to 31 March 2014), we can see that funds with the highest ActiveShare ratios (averaged quarterly from 31 March 2010 to 31 March 2014) have outperformed those with lower ActiveShare (< 85%), and indeed the group averages on a fairly consistent basis.

Therefore, in the Buttonwood article the average performance of the sample of “active” managers is being dampened down by the inclusion of what we consider to be closet indexers.

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