Seeking a Truly Active Fund Is Not Enough

Investors buying actively managed funds should seek out those with truly active managers. When active management is combined with skill, there is a greater likelihood of outperformance. The question is whether there is enough skill to overcome the dual challenges of efficient markets and higher fees.

A new study published in the Financial Analysts Journal (FAJ) supports the notion of seeking truly active managers. Its authors found that separate accounts with high levels of “active share” were more likely to have persistent outperformance. Separate accounts share similarities to mutual funds but are privately run and customized. Still, the findings have implications for mutual fund investors as well as exchange-traded fund (ETF) investors.

Active share is a measure that compares the weight of a stock within a portfolio to its weight within a benchmark index. A separate account or fund directly tracking a benchmark index, such as the S&P 500 index, would have no active share. A separate account or fund that holds no stocks within the index would have an extremely high active share level. The lower the level of active share, the closer the portfolio is to the index. Hence, the nickname for such actively managed funds and their managers is “closet indexer.”

We at AAII use R-squared to analyze how actively managed a fund is. R-squared indicates the percentage of a fund’s movement that can be explained by movements in the S&P 500. The lower the R-squared value is, the more a portfolio’s return can be explained by other factors.

With either measure, a manager with both skill and signs of being truly active should be preferred when considering an actively managed mutual fund, ETF or separate account. Otherwise, you will likely incur higher costs.

Having a comparatively high active share or a low R-squared is not enough. As the authors of the FAJ study wrote, “active share does not measure manager skill, but rather the extent to which managers apply whatever skill they have.” A fund or a separate account can have a portfolio that is truly active (high active share or low R-squared for its category) and underperform its peers at the same time. A truly active approach combined with better-than-peer returns and a low expense ratio is what investors should seek out.

Therein lies the problem. It’s not easy to do with mutual funds. When I looked at the returns of no-load, large-cap blend funds, only one with a low R-squared value beat the Vanguard 500 Index Admiral fund (VFIAX) on a one-, three- and five-year basis. The fund is Centre American Select Equity Investor (DHAMX). Its R-squared value is 75%. (The highest value is 100%. For purposes of disclosure, I own shares of the Vanguard 500 Index Admiral fund.)

Why haven’t other the low R-squared large-cap blend funds consistently beat the S&P 500? Cost is a big issue. The median expense ratio of these funds (defined as having R-squared values ranking in the lowest 20% of the group) was 1.24%. Vanguard 500 Index Admiral’s expense ratio is 0.04%. The median fund in this group has to outperform the Vanguard index fund by 1.2 percentage points each year just to break even in terms of returns after fees.

The types of stocks these funds are targeting is another reason. To the extent that the market is efficient (meaning stock prices reflect all known information), it is most efficient in the large-cap arena. These stocks are held by more investors, are covered by more analysts and are discussed in the media far more than their smaller peers. Therein lies the skill component. To outperform, a large-cap manager must have a very high level of skill.

A fund manager’s skill is more likely to be apparent in less-efficiently priced stocks, like small-cap stocks. Lesser attention creates more opportunities to succeed by being different than the index. Again, following a purely active strategy is not enough. In addition to skill, a fund’s expense ratio must be low enough to not offset any advantage the manager may have.