November’s FCA report on the asset management sector once again stressed the problem of underperformance among many active funds. For many investors this won’t be a revelation. It has long been known that many active managers may not have the skill to beat the market over the long-haul, hence the rise of passives in the first place. This is why it’s so important for investors to identify those handful of talented managers that can outperform, and why past performance is such an important metric.
However the report also highlighted another lesser-known metric that investors would do well to start paying more attention to: the fund’s ‘active share ratio’.
A first-time investor might presume that all actively managed funds sincerely try to beat the market, and that some fail by making the wrong calls. But some active funds don’t stray far from what an equivalent passive tracker would hold, and thus don’t even try (or try as hard) to beat the benchmark. It’s one thing to pay someone a fee to try, but fail, and another thing to pay someone a fee who then doesn’t even try at all.
This is essentially what the active share ratio measures. Take the weight of each stock in a portfolio minus the weight of that stock in the fund index or benchmark – the active share equals one half of the sum of the absolute differences in the portfolio and index stock weights, and will range between 0 (total tracker) and 100 (a portfolio devoid of any index stocks). This reflects the extent to which a fund tries to beat (or is simply different from) a benchmark by deviating from it.
The most egregious offenders here are what are referred to as ‘closet trackers’. The FCA report emphasises these as a major problem. It condemns the phenomenon of investors paying ‘active prices’ for products that simply take small positions on either side of the benchmark, noting that investors in these funds would do better to switch to an equivalent passive product.
The FCA scrutiny was prompted by an ESMA report that found that as much as a sixth of all active products across the continent could be characterised as ‘closet trackers’ – defined here as funds with an active share ratio of 60 or less. But what a lot of investors don’t realise is just how much variance there is above this point too. A fund with an active share ratio of 70 presents a very different investment proposition to one with 98. Ultimately it represents another dimension of risk – to what extent do you want and trust your manager to go against the crowd?
Many investors who put their money with active funds do so precisely because they have appetite for risk, and want superior returns. The passive sector already does a fine job for those that wish to track markets. Long-term outperformance often relies on having the skill to buy stocks when they are unfavoured, and exit positions while the running is good. By definition, this means breaking away from the norm.
For example, Cavendish seeks to offer a stock-picking, counter-cyclical approach with a view to long-term outperformance. This inevitably means going against the market consensus, which is why, for instance, its flagship Opportunities fund has a persistent active share ratio of 90+, usually closer to the upper 90s.
While the active/passive debate will continue to evolve, there will always be savvy investors with an appetite for risk, and consequently there will be a place for the best active managers that can consistently outperform benchmarks. For investors looking to find these funds, taking a look at active share ratios in addition to past performance isn’t a bad place to start – especially in cases where funds with high active share ratios are as competitively priced in terms of fees as their closet tracking competitors.
Cronan MacMahon is a director at Cavendish Asset Management.