Funds with High Active Share Could Outperform

During Periods of Heightened Market Volatility

In early 2018, the New York Attorney General reached an agreement with 13 major fund firms, requiring them to share how much their funds are actively managed.[i]  The information – called active share – can help investors stay informed as to how much active management they’re receiving compared to how much they’re paying in fees.

Active share is expressed as a percentage of the difference between securities in a portfolio versus those in a market index. If a portfolio shows an active share of 0%, the portfolio holdings are identical to the index. Conversely, an active share rating of 100% means the portfolio holdings are completely different than the benchmark index.

Generally, portfolios with an active share below 20% are likely to represent an index strategy, while those above 60% usually represent actively managed portfolios. Portfolios displaying an active share of 20% – 60% are generally categorized as “closet index” strategies.

Closet index funds have a higher probability of underperforming the benchmark. This is due to these strategies being marketed as actively-managed funds, with investors paying actively-managed fees in exchange for index-like returns.

However, a high active share does not necessarily mean a fund will outperform. In the first half of 2018, Morningstar reported that 36% of active managers both survived and outperformed their average passive benchmarks. This number was down from 2017, when 43% of active managers outperformed peers.[ii] One exception was in the intermediate-term bond category, more than 70% of funds in that category outperformed during the reported period.[iii]

As we know, however, past performance is never a guarantee of future performance. The relatively calm market cycle of the last decade has favored index funds, which tend to perform well in strong markets. Actively-managed strategies tend to have an advantage during times of heightened market volatility, due to active managers’ ability to provide downside protection by building valuation-sensitive portfolios with higher-quality securities.[iv]

Additional economic factors indicate that we could be headed into a more favorable period for active managers. Actively managed portfolios tend to outperform their peers in times of falling equity correlations and rising return dispersions. Active managers also typically outperform in times of times of less-accommodative Federal Reserve policy.[v] As we experience increased market volatility, a focus on actively managed portfolios could be beneficial.

It’s important to look for more than just high active share, however. Typically, funds with high active share have outperformed benchmarks when combined with low fees, experienced management teams, and low portfolio turnover. These characteristics work together to provide a higher probability for outperformance than other funds displaying only a high active share.[vi]

 

Investments involve risk including the potential loss of principal invested. Information and opinions contained herein that has been obtained from third party sources is believed to be reliable however accuracy and completeness cannot be guaranteed.

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[i] InvestmentNews. Apr. 6, 2018. “13 active fund managers agree to reveal closet indexing.” https://www.investmentnews.com/article/20180406/FREE/180409949/13-active-fund-managers-agree-to-reveal-closet-indexing  Accessed Dec. 13, 2018.

[ii] Ben Johnson. Morningstar. Aug. 23, 2018. “Active vs. Passively Managed Funds: Takeaways From Our Midyear Report.” https://www.morningstar.com/blog/2018/08/23/actively-managed.html  Accessed Dec. 13, 2018.

[iii] Ibid.

[iv] Sterling Capital Advisory Solutions. Oct. 2017. “Improving Environment for Active Management.” Accessed Dec. 13, 2018.

[v] Ibid.

[vi] Ibid.

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