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Beyond active share

September 02, 2016

Numbers don’t lie nor do they always tell the whole story. We’ve been singing the praises of high active share for years and still believe it’s a necessary ingredient for long-term outperformance. It’s just that numbers taken at face value with little-to-no scrutiny into how they were arrived at can be dangerous for investors.

When comparing potential investments, an obvious starting point is performance. A fund with a since inception return sitting around 8% is definitely worth a serious look, right? Yes and no. Performance, while important, isn’t always black and white. You must dig a little deeper into how that performance was achieved.

Having a few good years might be enough to spell success for you if you happen to time it perfectly – which almost never happens by the way. We’d suggest if your goal is to build wealth over the long term that you figure out how an investment achieved its performance. Although past performance isn’t a reliable predictor of future success, it probably makes sense to choose a fund that follows a consistent investment approach rather than the one that shot the lights out once or twice and has been sitting in the dark ever since.

The dangers of chasing high active share

Canada is notorious for closet indexers. Approximately 37% of mutual funds in this country are closet index funds.i That’s a big problem and it hasn’t gone unnoticed by the Ontario Securities Commission (OSC). Recently the OSC announced that it’s shining a light on mutual funds that charge for active management but really just hug an index to make sure managers who claim to be active actually are, or at a minimum make it obvious to investors if they’re not. We’ve highlighted the dangers of closet indexing and the merits of active share many times (Sizing up active managementBeing a better investor with active shareStructured for success). We also believe there’s an unexpected consequence that comes out of drawing attention to active share numbers – style drift.

Style drift is when a mutual fund switches course from its original mandate – in other words, the investment approach changes. This can happen over time as an investment grows and its market-cap flexibility shrinks. It can also change more dramatically with management turnover or when managers try to chase performance. This is worrisome for investors who thought they bought one thing and are now getting something totally different because it often impacts a fund’s risk/return profile. That’s concerning enough for investors. Equally concerning is the potential for managers who previously mimicked an index suddenly deciding they’re stock pickers because they want to boost their active share numbers. We don’t know about you, but when our money is on the line, we want our managers to stick with what they know. Remember, a high active share does not a stock picker make.

Relying on one big win

Don’t put all your eggs in one basket. Everyone’s heard that sage advice and yet many investors and managers do exactly that. It’s the allure of the big payoff. Going all in on one idea is dangerous because if it doesn’t pan out, you’re sunk.

The following chart illustrates that factor bets have been shown to detract from performance most over time when compared to closet indexers, moderately active investors, concentrated portfolios and stock pickers. A factor bet is an investment strategy that admittedly looks dramatically different from an index but where there’s little deviation in stock selection. Factor bets include portfolios weighted heavily in particular sectors or even choosing cash over equities.

There may be times when the bet pays off but any time you’re talking ‘bets’ you’re probably gambling more than investing.

Reflects annualized equal-weighted performance of U.S. all-equity mutual funds for five types of active management. Closet indexers do not deviate significantly from their benchmark. Moderately active funds do not have a specific style. Factor bets have large volatility relative to their benchmark but with small active positions. Concentrated funds actively choose stocks but are exposed to systematic risks. Stock pickers have large positions that differ from their benchmark. Returns net of fees and transaction costs. Excludes index funds, sector funds and funds with less than $10 million in assets. Source: A. Petajisto, “Active Share and Mutual Fund Performance”, Working Paper, December 15, 2010.

In contrast, more diversified stock pickers take a bottom-up view in that they choose individual equities they believe will outperform. According to the research, they’re the only ones to generate excess returns after fees and expenses and they’ve done so with less risk. This suggests that high active share is desirable if it’s the result of stock picking and less desirable if it’s the result of top-down market calls.

If you build a portfolio diversified by business idea, when mistakes happen (and trust us, nobody is immune) the impact is typically offset by those other ideas. We openly admit we’ve made mistakes and thankfully we’ve avoided the misstep of betting on one idea or sector so there hasn’t been any major fallout in our portfolios when these blunders happened. In fact, our winners have offset our losers by 6 to 1.ii We wear our losers like battle scars taking small comfort that they were all one-offs and not a single big idea gone wrong.

Some of our competitors haven’t fared so well. Here are some examples of funds that took a chance that didn’t pay off in the end.

High active share and solid performance are both important markers for success when choosing an investment. It’s equally important to pay attention to how performance was achieved rather than taking one number at face value. Was it generated by one or two big bets or from a consistent investment approach? With the OSC placing greater importance on active share, keep your eyes peeled for style drift – and we’re not talking about your investment manager deciding to embrace colourful socks. Picking stocks is easy, picking winners isn’t.

Annualized returns as at July 31, 2016:
EdgePoint Global Portfolio, Series A: YTD: 2.77%; 1-year: -1.08%; 3-year: 15.41%; 5-year: 16.66%; since inception: 16.70%.
iClare O’Hara, “Regulators launch probe into the ‘closet indexers’ of the mutual fund industry,” The Globe and Mail, March 2, 2016.
iiBased on the number of holdings since inception in EdgePoint Global Portfolio that made money vs. the number that lost money including fixed income (excluding holdings currently in the portfolio). In C$.