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John Rogers' November Market Commentary

December 27, 2012 | About:
Holly LaFon

Holly LaFon

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In 2012, we heard investors were thinking differently and more efficiently; they have wised up on portfolio construction. They now realize that beta, or market exposure, is plentiful and can be had for pennies, while alpha—the outperformance coming from active management—is rare and often more pricey. Under this rubric, the gameplan is to get market exposure through passive indexes and pay up for alternative investments such as hedge funds and private equity. We take issue with this theory on two levels. First, the data suggests that investors have more exposure than ever to high-beta, low-alpha “closet index” funds. Second, we think truly active managers are easy to find and come with modest pricetags.

In a presentation from this summer, bond giant PIMCO argued that investors should seek “unconstrained, less benchmark-oriented approaches.” And yet, PIMCO noted, this formula contrasts sharply with what investors have been doing according to the work of Antti Petajisto of the NYU Stern School of Business. Petajisto, along with K.J. Martijn Cremers, created and popularized the term “active share,” which is as simple as it is powerful. By comparing the stocks and weightings from a portfolio to an index, you can easily determine—in percentage terms—how much a manager has deviated from the index. And the more active a portfolio, the more potential for alpha. Petajisto’s 20101 study shows that investors in aggregate have become less savvy and thrifty when it comes to alpha. Specifically, in 1980 more than 95% of mutual fund assets went to highly active or active funds—but now only 50% of assets are held in such products. Passive investing, a reasonable and cheap approach, has grown from nearly 0% to 20% of assets. On the other hand, “closet index” funds (with active shares between 20% and 60%) have skyrocketed from a negligible market share to hold nearly one-third of all mutual fund assets. In their groundbreaking paper “How Active is Your Fund Manager?”2 Cremers and Petajisto were deeply critical of closet indexers, explaining how—on a mathematical basis—they have very little chance of outperforming a passive investment.

Petajisto’s most recent paper, “Active Share and Mutual Fund Performance,” offers an explanation for why closet indexing might be so popular and offers Ariel an opportunity for a little research of our own. Petajisto notes that closet indexing has not been a steady uphill trend. It peaked in the highly volatile 1999-2002 era, dropped during the relatively placid 2003-2006 period, and then rose along with volatility in the 2007-2009 financial crisis. He suggests that high volatility “gives managers more reason to stay close to the benchmark” because “high market volatility amplifies any return differences between their portfolio and the benchmark index” and thus “[t]he manager’s career risk for underperformance could therefore be greater in highly volatile markets and down markets.” This explanation sounds reasonable to us because the data supports it and it follows common sense: individuals respond to incentives, and job security is a massive one. Note that this argument suggests investors are not consciously shifting assets to index-huggers so much as their intermediaries, portfolio managers, are. Another important detail caught our eyes: Petajisto fairly consistently discusses trends using asset levels—dollar amounts. Moreover, in the list of benchmarks he used in his study, 969 funds use the S&P 500, and 469 use a variant of the Russell 1000 (growth, value,or core) indexes.

Meanwhile, just 278 funds use mid-cap indexes, and we know mid-cap funds tend to have lower asset bases. This got us wondering if closet indexing was largely a large-cap phenomenon.

So we turned to Morningstar data for a brief study. We ran active share numbers on all the funds in the midblend category, home to our mid-cap Ariel Appreciation Fund, versus the S&P 400 Index (Morningstar's preferred benchmark for the mid-blend category). We only used one share class per fund, and (like Petajisto) eliminated index funds and enhanced index funds. We found a very different story in our neck of the woods. For the 102 funds in our study3, the average active share was 92.5% and the median active share was 94.6%—a very far cry indeed from closet indexing. Indeed, we found only a couple of mid-blend funds that qualified as closet indexers. Ariel Appreciation Fund, by the way, has even higher active share than the average, 97.9%. For us, the important point is: in the large-cap space you must carefully avoid funds that look too much like the S&P 500 Index, but it seems much less problematic elsewhere.

Ultimately, then, to us there is an obvious, simple and cost-effective solution available to those who seek cheap beta as well as truly active managers to provide alpha. Institutional as well as retail investors can easily index large-caps and use highly active mid- and small-cap funds alongside them. While many are suggesting "true" alpha can only come via 2% management fees and 20% performance fees, our investigation into the matter suggests that outside large-caps, there are many highly active managers. When searching for one, as always, we think it makes sense to look for reasonable fees, very long tenures and clear, sensible strategies. Obviously, that is what we strive to be.

Investing in mid-cap stocks is more risky and more volatile than investing in large cap stocks. Ariel Appreciation Fund often invests a significant portion of its assets in companies within the financial services and consumer discretionary sectors and its performance may suffer if these sectors underperform the overall stock market.

The opinions expressed are current as of the date of this commentary but are subject to change. The information provided in this commentary does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security. Analyses and predictions are based on assumptions that may or may not occur, and different assumptions could result in materially different results.

Investors should consider carefully the investment objectives, risks, and charges and expenses before investing. For a current prospectus or summary prospectus which contains this and other information about the funds offered by Ariel Investment Trust, call us at 800-292-7435 or visit our web site, arielinvestments.com. Please read the prospectus or summary prospectus carefully before investing. Distributed by Ariel Distributors, LLC, a wholly-owned subsidiary of Ariel Investments, LLC.


1 Petajisto, Antti, Active Share and Mutual Fund Performance (December 15, 2010).

2 Cremers, Martijn and Petajisto, Antti, How Active is Your Fund Manager? A New Measure That Predicts Performance (March 31, 2009). AFA 2007 Chicago Meetings Paper; EFA 2007 Ljubljana Meetings Paper; Yale ICF Working Paper No. 06-14.

3 All active share values were provided by Morningstar.

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