Hi Guys,
MFO’s distinguished and intrepid researcher Ted recently posted a Barron’s article that addressed how to identify and select truly active mutual fund management. Ted’s work refreshed my memory of a similar article by Legg Mason’s Michael Mauboussin that provided a more detailed and more insightful discussion on the matter. Thanks again Ted.
The internal Link to Ted’s posting is:
http://www.mutualfundobserver.com/discussions-3/#/discussion/4521/active-funds-come-out-of-the-closetMichael Mauboussin is also a professor at Columbia Business School in New York city. He is an excellent communicator and writes with clarity. He provides ample illustrates that enhance the understanding of the subject under his microscope. Mauboussin’s contribution to the same topic is titled “Seeking Portfolio Management Skill”; here is a Link to the presentation:
https://www.lmcm.com/905988.pdfMauboussin collates active management to two parameters: Active share and Tracking error. He asserts that the measure of an active manager’s skill acumen is the sum of the active share and the tracking error components.
Active share is simply defined as “the percentage of the fund’s portfolio that differs from the fund’s benchmark index.” Of course that requires a careful selection of an appropriate benchmark.
Tracking error is commonly defined as “the standard deviation of the difference between the returns of the fund and of the index.”
The primary data source for Mauboussin’s paper is Yale’s Antti Petajisto; his 2010 paper is titled “Active Share and Mutual Fund Performance.” The study examined over 1100 actively managed mutual funds across a 20 year timeframe ending in 2009. Mauboussin continued the study by assessing over 400 funds over a roughly three year time-span. Basic conclusions from this second study reinforced the more extensive earlier research.
The takeaway conclusion is that positive Alpha (excess returns over benchmark rewards) was only achieved when the Active share percentage was north of the 80 % level while muted departures from the Tracking error (order 5 % to 10%) were practiced.
Significant departures from benchmark tracking (order 15 %) generated negative Alpha. Mauboussin termed this group of active fund managers “Factor Bets”. This group placed oversized bets on sectors that they projected as superior rewards producers. On average, they were wrong. Forecasting sector outperformance is hazardous business.
I recommend that you visit the Mauboussin paper, especially if you are a proponent of active fund management. The research demonstrates that the active fund management universe must be prudently segregated. There are many more losing strategies than winning strategies. Also, the population of mostly closet indexers among the active mutual fund population is increasing over time, and that subset can not recover its cost structure to warrant your attention or dollars.
Michael Mauboussin is also an engaging speaker. He has several online presentations on this subject. Here is a Link to a 3-minute video:
http://www.leggmason.com/globalthoughtleadership/VideoPlayer.aspx?VideoID=6/D+P82Xckw=Enjoy and profit from these findings. Active share and Tracking error measurements are yet other metrics to add to your investing toolkit. Good luck.
Best Regards.
Comments
Say you are looking at a fund manager that seems to have decent returns. There are a few possibilities for how the manager generated those returns:
- The manager could be just a "closet indexer," meaning that while the portfolio is not exactly like the index, it is close enough that it is unlikely to ever beat the index (and in fact will likely underperform over time)
- The manager could be making "factor bets," meaning making oversized bets on certain sectors (or other factors). Sometimes these bets will pay off but overall they will fail.
- If the manager is a truly skilled stock picker, then 1) the portfolio will be significantly different from the index and 2) the portfolio will not significantly overweight certain sectors.
For investors to put this into practice, we can look for funds that with portfolios that are very different from the index (one way might be to identify funds that only hold 20-50 stocks) *and* that have sector weightings that are similar to the index. (On Morningstar, the portfolio page for a fund shows the fund's sector weightings compared to both its benchmark and its fund category.)
Now I wonder what funds might meet these criteria?
Hi Claimui,
You have indeed successfully grasped the basic findings from the Active Shares study.
Keep in mind that I referenced the research as an additional tool to supplement whatever actively managed mutual fund selection criteria you currently deploy. It does add to a decision making toolkit.
But it is not proffered without some controversy. Getting the data to implement it in fund tradeoff comparisons is difficult and likely a costly proposition. Morningstar is prepared to provide the data, but it charges for the service. On a more meaningful front, researchers have challenged its usefulness as a reliable and stable forecasting tool.
Vanguard has recently published (May 2012) a paper that addresses the Active Share concept directly, and finds it with little forecasting merit. To quote Vanguard: “Higher levels of Active Share did not predict outperformance.” Here is the Link to the Vanguard study:
https://pressroom.vanguard.com/nonindexed/active_management.pdf
The title of the Vanguard paper is “The Search for Outperformance: Evaluating Active Shares”. The authors for the work are Todd Schlanger, Christopher B. Philips, and Karin Peterson LaBarge. Remember that the work was completed under the auspices of the Vanguard organization, so some institutional bias may have influenced its direction.
The paper’s Executive Summary is included here. Its last sentence is especially pertinent given our present exchange.
“Active Share is defined as the percentage of a portfolio that differs from a benchmark index. Designed to determine the degree of active management in an actively managed portfolio, active share is also helpful as a manager evaluation tool. It can be used to compare the appropriateness of different benchmarks and to check for consistency in a portfolio’s investment strategy over time. Interest in this measure has been increasing as a result of the difficult performance environment active equity managers have faced recently, and also because some earlier studies found that high active-share funds were more likely to outperform.”
In its paper, Vanguard reports that the outperformance expectation is a myth. Please examine the report that ultimately dismisses the outperformance claim as excessive. This is no silver bullet according to Vanguard.
Since securing current Active Share fund data is likely to be a costly process, some poor-man options have been identified. Examine the top ten holdings in the candidate mutual fund and compare it against the top ten holdings in the benchmark portfolio. Also, examine the correlation coefficient of the fund against its benchmark.
If these comparisons show a high degree of holdings overlap and if the correlation coefficient is very high (say 98 % or 99 %), the candidate fund is a closet indexer. If these signals show little overlap and the correlation coefficient is below the 80 % level, the candidate fund is likely in the active stock selection category.
I’m sure you’re cognizant of the observations that both manager tenure and costs are respected indicators when making a solid fund choice. The longer the tenure and the shorter the fees, the more likely that the fund will deliver superior returns. These factors tilt the odds towards oversized rewards.
I also like to review the funds Alpha (excess returns) history over several timeframes, the longer the better. The stability of that number, as characterized by its Information Ratio, is a great persistence signal.
Be aware that I am a very conservative investor and am in the drawdown phase of my portfolio management. I act slowly and incrementally. I own a very mixed portfolio that has large passive Index components. I operate with actively managed mutual funds at the fringes, mostly as a challenge to test my market awareness and alertness. I anticipate only small benefits from this exercise.
History demonstrates that even very successful institutional active portfolio managers struggle to generate excess returns that are more than 2 % above a representative benchmark over any extended timeframe. It is an asymmetric risk since the downside potential is a much higher percentage. You get to choose your own poison.
Some debates never end. That’s particularly true in the investment universe given the dynamic environment, many smart motivated participants, and the overarching drive towards a never-quite there efficient market. Eruptions appear and disappear quickly in our highly networked and computer dominated world.
Best Wishes.
If you want active management, it makes sense to seek high "active share". However, having high active share simply says the fund is different than the index and fund manager purposefully went out and actively selected non-index components. It does not man fund manager was wise and good at stock picking and the choices he made can turn out to be dud.
In 90s the S&P 500 index itself was leading most managers and market was momentum driven and index composition actually reflected that. So, high active share funds did not necessarily turn out to be successful.
I would like my fund manager pick index components if those are the best choices at the time. I do not care if the fund does not have much high active share at the time. It can change based on market conditions.
Apart from that having index funds is really good idea given consistent index beating performance is rather rare. A lot of active bets that investors made with various mutual funds and stock actually did not perform as well as indices (but we only see that after the fact) but hope streams are eternal and we continue to buy active funds.
I went to Bloomberg's fund ranking tool and screened for "blended" funds to find funds that match the index. I uncovered Oceanstone Fund, OSFDX. It presently holds 17 stocks (concentrated strategy) and a lot of cash (37% of the AUM) right now.
From the funds' shareholder report during the 2009 reset:
"During the recent economic downturn, a large number of companies lost their
profitability due to sudden and severe decrease of demand for their products or services,
and their E became a negative number. These companies were durable businesses and
had a good history of profitability. So it was reasonable to assume that these companies
would likely regain their profitability in an economic recovery."
2009 shareholder report
I believe the cash position along with their research provided this fund (manager) with the opportunities of buying assets cheap during say the 2009 meltdown. Take a look at OSFDX and its impressive performance soon after the 2009 crash. A fund like this follow the index most of the time and then using its cash position buy stocks "on sale" and hopefully out perform.
FTQGX, Fidelity Focused Stock Fund, is another fund that seems to be getting these metrics right. It has 50 stocks and has outperformed the index over the long term very consistently.
MXXVX, Mathew 25 Fund, 25 stocks and a consistent out performer compared to the index.
VPCCX, Vanguard PRIMECAP Core Inv, less concentrate with 137 stocks
UMBMX, Scout Mid cap, 87 stocks
This just illustrates the difficulty in chasing great returns: Hopefully one can do it in certain cases, but one should not jump into it without a really good research.
I’m not familiar with any of the four funds that you mentioned; I’m definitely not a mutual fund junkie. So initially I could not answer your question with regard to the Active Share status of any of these funds.
But the chart that you presented grabbed my immediate attention. It is impressive. So I went to Morningstar to collect a few measures of the Oceanstone portfolio, and the investment style and philosophy of its manager, James Wang.
Even without the benefit of a specific Active Share percentage, other fund assessment factors clearly signal that the Oceanstone mutual fund (OSFDX) is solidly in the Active Share category.
Currently, given its outstanding positive Alpha (excess returns) record, that’s a good thing. But as MFO member Investor commented: that’s potentially a double-edged sword; it can be either good or bad with respect to investment outcomes.
From Morningstar, the OSFDX portfolio characteristics demonstrate that manager James Wang is decidedly in the value camp. He buys undervalued, cheap stocks. He has studied Benjamin Graham and Warren Buffett, and seems to be a dedicated disciple. In many respects he appears as a committed member of the Graham-and-Doddsville School of superinvestors made famous by Buffett and others. There is much to be admired with this principled discipline.
However, all is not necessarily sweetness and light here. By itself, the value discipline does not guarantee success. Some cautionary factors must be recognized and should influence any investment decision.
James Wang is a one-man, reclusive, solitary operation; he has no deep bench whatsoever, and does his own research. History proves that pure self-reliance works until it stops working. In ancient times China was a dominant world power until a single ruler decided he didn’t want “international” trade, burned all his ships, and isolated his nation. China is still recovering from that single misguided decision. Investors should be extra cautious when dealing with a one-man investment shop. It lacks diverse thinking and is deficient in the independent wisdom of the crowd.
Wang deviates from the Graham-Buffett investment style with his trading frequency. He does not buy-and-hold for long periods although his evaluation and selection criteria emphasizes long term recovery to normative Price-to-Earnings ratios. His portfolio turnover rate exceeds 100 %.
At a 1.8 % expense ratio, the fund is rather costly. With a currently very high fund cash reserve position, an investor is paying a premium for the manager to simply hold his money. It is true that Wang may be holding that reserve for a proper market entry point, but that’s market timing; numerous academic studies conclude that market timing is overall a loser’s game.
Wang seems to be a go-anywhere investor. That’s okay for him, giving him complete flexibility. That might not be acceptable to a disciplined private investor who wants a stable style and category of investing to fill a specific hole in his own portfolio.
In the investing universe, as almost everywhere else, there is a strong pull towards a regression-to-the-mean. Yes, James Wang generated noteworthy excess returns. That was yesterday; can he maintain that superior performance tomorrow? The odds are undoubtedly against him. Just reflect on all the fallen, and sometimes disgraced, investment heroes in our recent history.
James Wang’s OSFDX portfolio correlation coefficient relative to its S&P 500 benchmark is changing over time. Based on his 5-year record, the correlation is in the 0.5 range; based on his 3-year record, the correlation has shifted significantly towards 0.8. That’s directly reflected in his more recent returns record.
The Oceanstone fund has exhibited high volatility (standard deviation) relative to its benchmark. If you invest, there will be plenty of ups and downs. An investor in OSFDX must be prepared to accept a rollercoaster ride.
Active Share investing is a gamble. Sometimes you win; sometimes you lose. The earlier referenced Vanguard study made some pertinent observations that are worth repeating here.
From the Vanguard report: “ It is not enough to be different. The portfolio manager’s bets must also be accompanied by manager skill.” Also, “Active share by itself does not indicate whether a fund will outperform a benchmark”.
Based on their findings, the Vanguard researchers recommended that “because of the significant performance dispersion of high active share funds, investors might consider using such funds as a satellite to complement a broadly diversified core equity portfolio”. That’s sound advice.
I hope this helps. I have no ponies in the Active Share race.
Best Wishes.
I think the fund is similar to the Fairholme funds FAIRX and (to a lesser extent) FAAFX. FAIRX has done well this year; FAAFX less so (mostly due to last week). Last year, the performance was reversed. However compared to Fairholme, OSFDX has a number of problems as mentioned in your post and discussed elsewhere on this board (and also mentioned in one of David's past commentaries).