Here’s a remarkable initiative from the U.K., which you should not expect to see replicated here in the U.S., despite its significant value to investors.
Neptune Investment Management, an active equity fund manager in the U.K., has announced that it will publish the “active share” if each of the funds it manages.
What does this mean?
Well, a fund’s active share is a measure of the extent to which the stocks in its portfolio differ from those comprising the index against which it should be benchmarked. For example, a large-cap U.S. equity fund might reasonably be benchmarked against the S&P 500. Now, if ABC large-cap U.S. equity fund holds, say, 200 stocks, broadly diversified across various economic sectors (e.g., energy, . technology, finance), then it might reasonably be accused of closet indexing. Since we can own an index fund at far lower cost than active managers charge, there’s no point in owning an actively managed fund that looks pretty much like, say, the S&P500.
There are four ways an actively-managed fund’s holdings can differ from those of its benchmark index: first, it can hold stocks not included in the index (but if it does this too much–for example, having 25% of its holdings in foreign stocks, then it should not be measured against an all-US stock index at all); second, it can omit stocks included in the index (after all, if the stocks it chooses not to buy are among the weakest performers, that will boost the fund’s relative return); third, it can hold a larger position in a stock than the weight of that stock in the index (for example, if 3% of the fund is invested in McDonald’s whose weight in the index is only 0.5%, then this overweight to McDonald’s will pay off it that stock outperforms); finally, it can hold less of a stock than its weight in the index (for example, if the fund holds only 1% in Apple, which constitutes 3.85% of the S&P 500, and Apple underperforms, then that will benefit the fund’s relative return).
In other words, another way to think of a fund’s active share is to ask how much its holdings overlap with those of the benchmark index. In my book, Simple, Smart Investing, I illustrate this concept with a Venn diagram. One circle represents the index. A second circle, overlapping with the first, represents the actively-managed fund. If those two circles overlap a great deal, then the fund’s active share is very small–in other words, its chances of outperforming the index, net of fees, are remote. If the circles hardly overlap at all, then the fund’s active share is large, which means that its performance is likely to deviate from that of the index by a lot–for better or for worse.
Now, if active fund managers believe in what they do (that is, believe they can generate better performance, net of fees, than a dumb, passive index fund), then they should be willing to tell prospective investors just how big their active share is; in other words, just how much their fund’s holdings differ from those of the index they should be measured against.
But they won’t. Why not? First, because mutual funds with a very high active share (for example, funds that hold only about 12-15 stocks) have historically performed even worse than more diversified stock funds.
Secondly, active fund managers are afraid that prospective investors will do a little math that might help them determine how likely their fund is to outperform the index net of fees. For example, if a large-cap US equity fund has an expense ratio of 1.10% vs. an S&P 500 index fund’s charge of 0.10%, then the active fund has to outperform the index by one full percentage point (100 basis points) just to realize the same return net of fees. But wait, if the fund’s holdings overlap with those of the index to the tune of, say, 50%, then we can say that half of the active fund’s return is going to equal that of the index (same holdings, therefore same return), which means that 100% of the manager’s outperformance must be generated entirely by that half of the portfolio that doesn’t overlap with the index. In the example I’ve just given, that means the active share of the fund must outperform the index by 200 basis points for the whole fund to generate the same return as the index, net of their respective fees.
That’s a very tall order, and is why two-thirds of actively managed US equity funds have consistently failed to outperform their benchmark in virtually all three-, five-, and ten-year periods on record.
Last year was a particularly brutal year for actively-managed US equity funds, with only about 16% beating “the market.” Which means, of course, that investors in those funds once again suffered the double indignity of paying higher fees for lower performance. How come? Well, the single most common characteristic of actively managed US equity funds is that they systematically underweight the largest-cap stocks. Consequently, in years like 2014 when the largest-cap stocks generated higher returns than did mid-cap or small-cap stocks, actively managed US equity funds always underperform. But if as an investor you want to systematically underweight the largest cap stocks, you can still do that through low-cost index funds; for example, by giving greater weight to mid- and small-cap stocks than their weight in the Russell 3000 index. (I’m not saying you should do this, just that you could do this!.)
Getting back to Neptune Investment Management: should U.K. investors assume that because the firm is willing to publish the active share of its funds, therefore those funds are likely to outperform? No. All we know is that the firm’s managers believe they can outperform. And, of course, that’s what most active managers believe, year after year, even in the face of evidence to the contrary. As Upton Sinclair wisely noted, “It is difficult to get a man to understand something, when his salary depends upon his not understanding it.”
The obvious takeaway? Actively-managed mutual funds consistently over-promise and under-deliver, successfully diverting investors’ cash into the pocket of fund management companies that repeatedly fail to provide any added value for the high fees they charge. This is why more and more investors in both the U.S. and the U.K. are directing their hard-earned savings into low-cost index funds. And so should you.