Investors are weary of being overcharged by closet indexers posing as active fund managers, but a new report has found that measuring the performance of active managers is not as clear cut as it seems.

Active share has been commonly used by investors to measure a fund manager’s activity against a passive benchmark, but a new report from investment research firm Morningstar titled ‘Context is everything when using active share’ has found that the method is highly context-dependent.

The study also found that high active share funds do not typically have better odds of higher returns for investors than their less-actively investing peers.

William Chow, Morningstar’s director of manager research, told AsianInvestor that based on the findings, using a single yardstick, such as a 60% limit for separating active and closet-indexing funds, might have been useful in the US stock market, but it’s not meaningful across all fund markets.

“For instance, an active share of 60% might be quite low for some markets such as Global Large-cap Blend equity as the index is less concentrated with more constituents, but it is very high for some others such as Singapore equity which has highly concentrated benchmarks and a short list of constituents,” said Chow.

RELATIVE ACTIVE SHARE

Morningstar’s report covered 43 categories that span Asian and European single-country markets and regional categories, as well as global developed and emerging markets, over a 10-year period until 2020.

Using blanket labels, for instance marking 80% as high and 40% as low, is not meaningful across different markets because a category's median active share and index concentration must be considered together, the report wrote.

In concentrated markets, active shares tend to be far lower. For example, Singapore registered the lowest active share level among Asian markets because its 10 index constituents represented 82% of the index weight.

Conversely, in a broadly diversified market such as European equity markets, a portfolio manager can actively manage funds more easily without excessively deviating from the index than in a concentrated market.

As such, the study argued that drawing a limit between what can be considered an active manager and a closet indexer cannot be a one-size-fits-all judgment. It also proposed a relative framework to classify funds based on their level of active share against a relevant market.

“We suggest that investors should reference a fund’s active share relative to its peer group or market. The Relative Active Share framework allows investors to gauge whether a fund’s active share is considered low or high within its relevant market, thereby enabling investors to determine whether the level of fees commensurate with the level of active risk taken by the manager in general,” said Chow.

BETTER PERFORMANCE?

The claim that high active share funds offer a better chance of market-beating returns has been a topic of vigorous debate among investors and researchers. The results of Morningstar’s study conclude that there isn’t a consistent link between high active share scores and superior returns in the funds across the 43 examined categories.

In the China A-Share category, all active share quartiles produce substantial excess returns, reflecting the inefficient state of the highly volatile onshore Chinese market, which is predominantly driven by short-term retailers (representing over 80% of average daily trading volume) and local portfolio managers (average portfolio turnover of over 300% per year). In contrast, in Greater China, the most active funds have lost to the index more than the others. Mostly this is due to their bias toward smaller capitalisations, which have done worse in the market.

Funds with higher active share also tend to charge more, and higher fees also pose a higher threshold for the manager to cross before reaching even the returns of low-cost funds. The higher the threshold, the more active risk is needed to gain even zero alpha on an after-fee basis which can in turn lead to considerable relative losses.

“Higher active share does not automatically translate to higher returns, so investors shouldn’t focus necessarily on high active share alone when choosing funds for outperformance,” said Chow.