In Chris Inifer’s last post, he explained the silent risk of passive investing. The debate about active versus passive fund management is not new. But when one sifts through all the arguments, academic research and evidence, three things become clear:

  1. The average active manager underperforms (roughly by the extent of their fees).
  2. Not all active managers have the same approach.
  3. It is crucial to make sure that you aren’t paying for active management and getting a closet index or quasi-tracker fund with limited active bets against the benchmark (refer to point 1.)

‘Closet indexing’ can be a survival strategy for funds, but it gives clients a poor outcome

Active asset managers that deliver alpha by outperforming their respective benchmarks tend to be rewarded with more money to manage. But history has shown that after a period of good performance, many of these ‘active’ managers then tend to revert to ‘closet indexing’. They stick close to the index so that they aren’t the worst performer amongst their peers in order to retain the assets. The result is that despite warnings about past performance, many funds that are perennial underperformers continue to exist simply because they have done well in the past.

For clients, this translates into a terrible outcome. Clients have an underlying portfolio that is very similar to the index but they are paying an active fund manager fee for that privilege. So, the popular question, ‘Why must I pay a fund manager if I can access the index without the fees for active management?’ is fair in many cases.

One can’t be a truly active manager and worry about tracking error as a measure of risk

The point of investing with an active manager is to receive a better return than the benchmark. But some people focus on tracking error as a measure of risk. Tracking error is a measure of the degree of differentiation from the benchmark. Funds with a large tracking error are seen or described by some professionals as ‘risky’. This view of risk does not make sense for truly active managers. How can you pay a manager a good fee to get a better return than the benchmark and peers if they are unable to deviate from the benchmark or their peers?

How ‘active’ is your fund manager?

Fortunately, academics¹  have devised another method to measure how active your fund manager really is. This measure is called ‘Active Share’. It measures the extent to which a fund’s holdings differ from the benchmark’s holdings. A fund with a high percentage ‘Active Share’ would differ significantly from the benchmark where a lower percentage would be considered less active or even a ‘closet index’ fund.

Additional research²  found that in the United States:

  1. Managers who act with conviction and deviate from the benchmark outperform the market over the long term.
  2. Managers that stuck close to the benchmark, underperformed the market roughly by the amount of fees that they charged.

Not all active managers are the same – be sure that you are getting what you are paying for

What about the Australian experience? From the chart below, we can see that the top five ‘active’ funds in Australia (by size) are not ‘active’ according to this measure and would fall into the category of being a ‘closet index’ fund. In contrast, the chart shows that Allan Gray is an active manager.

Active share_Aug 15_v2

Source: Morningstar

In conclusion, when you invest in an active manager, be sure that they are really investing actively and aren’t just a ‘closet-index’ fund in disguise. When selecting an active fund manager, the question that you need to ask is: Are they true to their label of being an active fund manager?


¹ How active is your fund manager? A new measure that predicts performance by Martijn Cremers and Antti Petajisto, Review of Financial Studies, August 2009.

² Active Share and Mutual Fund performance by Antti Petajisto, Financial Analysts Journal, Volume 69, Number 4.

LJ Collyer is a Relationship Manager at Allan Gray. LJ holds a Bachelor of Commerce (Honours – Stellenbosch University), MBA (University of Cape Town) and is a CFP in South Africa.