Research has demonstrated that the average fund manager has historically underperformed a low-cost index fund after fees and expenses. This should not come as a surprise considering that the average fund holds over 100 stock positions today and turns over nearly the entire portfolio on an annual basis. Yet, these closet index funds – who stay very close to the benchmark while actively racking up trading costs – account for roughly one third of all mutual fund assets today. Closet indexers may not be doing much for their investors, but at least they are keeping the brokers happy with all those commissions. As an aside, if closet indexing still sounds appealing, you will love this – How Investors Lose 89 Percent of Gains from Futures Funds
Many investors are well served by simply allocating to low cost beta, given the array of research published on the underperformance of the average manager. And within the context of a properly constructed portfolio, this approach has its place. However, what John Bogle may not tell you is that not all active managers are created equal. A recent issue of the Financial Analysts Journal demonstrates that despite the chronic underperformance of closet indexers, the most active stock pickers outperform their benchmark, even after higher fees.
Active Share is a helpful statistic to gauge how much a given portfolio differs from the benchmark. It is simply the percentage of a fund’s portfolio that differs from the index and serves as a reasonable proxy for stock selection. The figure below illustrates the two dimensions of active management along with some examples of mutual funds in each category.
The best performers are the smallest funds within the stock picker group. This is somewhat intuitive as inflows follow success, making it more challenging for larger funds to “look different” than the market. At the time of this study, the largest equity mutual fund in the United States was the Growth Fund of America, which had more than $140 billion in assets at the end of 2009. The chart below illustrates the spectacular decline in the fund’s Active Share as assets have grown from under $40 billion in 2002 to as high as $200 billion in 2007. Balancing investment success with the resulting inflows of assets is a challenge for many institutions, but the fall in Active Share at American Funds would suggest that the firm has chosen to grow AUM at the expense of future performance.
“Economically, these results mean that stock selection as indicated by high Active Share is rewarded in the stock market, and the most aggressive stock pickers are able to add value for their investors even net of all expenses.”
We couldn’t agree more. Investors should focus their time, energy and capital on good stock pickers while paying attention to measures of active management. Clearly, just being different from the benchmark isn’t, by itself, a recipe for outperformance. But closet indexing is certain to produce subpar returns. As Sir John Templeton famously stated, “It is impossible to produce superior performance unless you do something different.” Superior performance, in our view, is generated largely by patience, discipline and the conviction to act with boldness when an opportunity presents itself. Exceptional returns are created by concentrated portfolios, as excellent ideas are few and far between.
Unfortunately, rather than strive for long term excellence, most managers have become closet indexers in order to avoid the risk of falling in the bottom quartile of their peer group in the short term. The safest way to do that, of course, is to get back into the closet and hug the index. Conversely, we recognize and fully accept that our own process may not be the best way to stay at the top of the pack in any given year, but the evidence suggests that it produces a portfolio better able to avoid permanent capital loss and increases the probability of success over the long term. Consequently, the Active Share of the Broyhill High Quality Dividend Portfolio stands around 85% today. We think that constructing a portfolio free from self-imposed benchmark constraints is a lot more fun than hiding in the closet worrying about career risk.