The value of (truly) active investment

December 3, 2014

Dec 3 (Reuters) – If you are going to go with active
management you perhaps ought to go all out.

The more your mutual fund trades, the better it will do,
particularly if it is small and charges high fees is the upshot
of a new study. While some questions are unanswered, the active
versus passive investment debate is more complex than the
aggregate data showing active underperformance shows.

“We find that active mutual funds perform better after
trading more. This time-series relation between a fund’s
turnover and its subsequent benchmark-adjusted return is
especially strong for small, high-fee funds,” the authors of the
study, Lubos Pastor of the University of Chicago and Robert
Stambaugh and Lucian Taylor of the University of Pennsylvania,
write. (here)

“These results are consistent with high-fee funds having
greater skill to identify time-varying profit opportunities and
with small funds being more able to exploit those
opportunities.”

Presuming that funds trade more when they see better
opportunities, the study sought to relate trading activity to
subsequent performance, looking at data from more than 3,000
active U.S. equity mutual funds from 1979 to 2011. The findings
were strong: a one-standard deviation increase in turnover
brings with it a 0.65 percentage point per year increase in
return for the typical fund. What’s more, this increase is
greater among smaller funds and those which charge higher fees.

Much of this is consistent, at least superficially, with
earlier studies which find diminishing returns to active
management among larger funds, and, indeed, as the industry
itself gets larger. This may be because larger funds, and a
larger industry, are less able to exploit mis-priced stocks when
they see them.

So it stands to reason that smaller funds are better able to
put on trades of a size to make an important difference to their
returns when they see inefficiencies. Further, the more good
trades they see, the more they trade, thus driving the
correlation between activity and subsequent returns. Further
yet, to the extent that skill exists, it also seems to make
sense that managers are able to extract extra compensation for
it in the form of fees.

To be sure, this study isn’t an argument, in and of itself,
for going all-in on active management. What it does seem to
indicate is that there is a value to active management and that
investors should be careful and vigilant about what they are
paying for and why. This, in its own way, is no different than
the case with types of quasi-passive investment management now
popular.

AN INDEXER BY ANOTHER NAME

All of this is also consistent with a 2013 paper which found
that the most active stock pickers actually outperform the
market, even taking into account fees and transaction costs. The
study, by Antti Petajisto of New York University and fund
manager Blackrock, actually defined ‘active’ slightly
differently, measuring funds not by how often they trade but by
how much they deviated from their underlying benchmark.

The most active group in Petajisto’s study beat the index by
2.61 percent annually and managed to outperform by 1.26 percent
a year even after fees. Those funds, in other words, are taking
on more risk relative to their comparative performance, but are
getting more in exchange.

It is important here to consider the issue of career risk.
Since fund managers survive and are paid based on their
performance against a benchmark, they, depending on their
abilities and temperaments, tend to adopt different strategies.
One strategy is to make bigger bets. The advantage for clients
is that this approach will tend to unmask a lack of skill,
leading to a short career.

Other managers, either because they are risk averse or less
talented, turn into what are sometimes called ‘closet indexers,’
hugging closely to an index so as to minimize the risk of career
ruin. This can be especially tempting when the fund they manage
has grown to a considerable size. Then they face a dual problem:
the risk of losing a lucrative gig and a lack of good, large,
liquid investment opportunities. The result can look a lot like
an index fund, but with very high fees.

“The problem is that closet indexers are very expensive
relative to what they offer,” Petajisto writes. “A closet
indexer charges active management fees on all the assets in the
mutual fund, even when some of the assets are simply invested in
the benchmark index.” (here)

On his criteria, about one third of mutual fund assets in
2009 were with closet indexers which were making only small
deviations from the index.

The active versus passive debate is far from over, but with
evidence of value being created by both expensive and very cheap
funds, the middle of the pack looks like the place to avoid.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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