In the paper, The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees, and Performance, a distinction is made between funds pretending to have active management but are quite similar to an index such as the S&P 500 ETF (SPY), and actively managed funds that use targeted stock picking. Before we compare the two classes of active fund investing - is this really a global problem?
Using the definition outlined in the paper that tracks the percentage of portfolio holdings which differ from the benchmark index (called Active Share), and using the suggested 60% threshold as the cut-off for true active management - we get the following figures for "active funds" that are really closet indexing:
- USA - 13% of active funds
- Canada - 40% of active funds
- France - 63% of active funds
- Poland - 81% of active funds
- Total Non-US - 38% of active funds
- Total (incl. US) - 22% of active funds
Closet Indexing vs. Active Stock Picking Returns
As a whole, only 45.5% of "active funds" were able to beat the underlying index when looking at global statistics (according to aforementioned paper). But what happens when we begin to separate funds into categories with relative degrees of closet indexing? Remember that the percentage of Active Share is the amount of difference between fund and index. 0% Active Share is a perfect mirror to the fund and 100% is completely different. The numbers below are represent funds around the world:
- Less than 60% Active Share - only 23.5% outperform the market
- 60% - 90% Active Share - 42.5% outperform the market
- Over 90% Active Share - 60.2% outperform the market
- Less than 60% Active Share - under-perform by 0.13%
- 60% - 90% Active Share - outperform by 1.63%
- Over 90% Active Share - outperform by 3.64%
An Individual Investor Testing The Theory
Below is my 'individual investor' test of the theory. I selected a high-yielding strategy that picks up a large amount of REITs, MLPs and other high-yielding products.
To create a benchmark of sorts — I take the MLP universe of stocks and restrict it to companies trading at a minimum $5 per share and 50,000 shares daily. This 'index' is rebalanced annually in order to include newer firms. It is equal-weighted. Slippage of 0.5% will represent slippage plus trading costs. Since there is no strategic targeting of stocks, there should be no advantage to more frequent rebalancing other than faster inclusion to our "index" and higher trading costs might erode value. We will test this theory as well. (Chart compliments of Portfolio123.)
- CAGR (total return) 12.35% (annual rebalancing)
- CAGR (total return) 12.6% (semi-annual rebalancing)
- CAGR (total return) 12.3% (quarterly rebalancing)
- CAGR (total return) 12.34% (4 week rebalancing)
Next, I refine the rules with a couple of comprehensive ranking systems (Portfolio Café — Big Bad Yields). These ranking system look for earnings and revenue growth, debt ratios, and deep value. Furthermore, we will require a minimum of 100,000 shares daily to minimize slippage — although we will keep the 0.5% per transaction. The first test will be use the same annual rebalancing. While we use some strategic timing rules, I will not include market timing that is used in the Portfolio Café model. We stay 100% invested at all times. We only keep the top 15 stocks — which in itself will give us high Active Share. Below is a description of five sample picks as of April 1st 2012:
|(TAL)||TAL International Group, Inc.||84.76||1232.19||5.99|
|(PMT)||PennyMac Mortgage Investment Trust||83.46||561.26||11.78|
|(MAIN)||Main Street Capital Corporation||93.2||657.98||6.82|
|(PAA)||Plains All American Pipeline, L.P.||94.43||12596.62||5.23|
|(CYS)||CYS Investments Inc||83.52||1462||15.28|
- CAGR (total return) 12.55% (annual rebalancing)
- CAGR (total return) 14.47% (semi-annual rebalancing)
- CAGR (total return) 16.42% (quarterly rebalancing)
- CAGR (total return) 21.1% (4 week rebalancing)
What happens once we include market timing — similar to the model on Portfolio Cafe? In addition to lower portfolio drawdown, the total return rises to 29% annually after accounting for slippage (see chart below).
Active, Closet and Passive Investing
The lesson learned? If you are re-balancing without an active stock picking strategy (simply putting assets classes back into target weights), you need to carefully weigh any gain against the cost of trading.
On the other hand, if you are rebalancing with a specific strategy in mind and are weeding out low ranking companies to be replaced by quality firms, you stand a higher chance of beating the underlying benchmark. This goes for funds as well — if your active fund looks suspiciously similar to the underlying index, you might want to consider switching funds even if only to an index ETF that has lower management costs.
Alternatively, you can follow the recommendations of the above referenced papers and look for smaller funds that outperformed last year that are substantially different in holdings and relative weighting to the benchmark as you seek to isolate superior fund managers. Or create your own strategic portfolio if you have the time, skill and desire.
*This article is a re-print from the Portfolio Cafe blog with approval by the author.