Determining Truly Active Management

If you want to beat the index, you can’t look like the index

For many do if yourself investors actively managed mutual funds are considered to be a sucker’s bet. They believe that active funds offer nothing more than poor investment returns and high fees. Their rationale is that you can simply go out and buy a low cost ETF that will provide the same investment exposure at a much lower cost. Sure, you won’t ever beat the index, but you also aren’t expected to underperform by much more than the MER.

There is much support for this position too. Many of the personal finance columnists are firm believers in low cost ETFs, and the regular SPIVA Report which compares active managers to their benchmarks more often than not shows indexing the winner over the long term. Even putting the investment universe we follow through our valuation model, only 50% show a higher absolute or risk adjusted return than their benchmark.

With all of this compelling evidence, why would anybody even consider investing in active management? Quite simply, active management can produce better risk adjusted returns. However, identifying those managers who are truly active can be a challenge.

The reality is that there are a number of managers that engage in a practice known as closet indexing. With closet indexing, the manager is looking to keep their performance in line with that of their benchmark. There are a number of reasons that this happens such as looking to control risk, or hoping to keep performance close to the index to keep investors happy, or in some cases, managers may do this to keep their jobs.

Regardless of the reason, it severely limits the ability of the manager to manage the fund in such a way as to give them an opportunity to outperform their benchmark and add any value for investors. If you knew before hand that you were essentially destined to get a return that is roughly that of the index, then why would you pay a higher management fee to earn roughly the same return?

According to a study that was done by Martijn Cremers of the Yale School of Management, closet indexing is quite prevalent in Canada. He estimates that approximately 40% of the funds in Canada would be considered closet indexers, with most of it occurring with Canadian equity funds where it is estimated that 70% of the funds engage in the practice. Global and international equity funds typically do not engage heavily in the practice, while about 13% of the regional and sector funds are closet indexers.

Using this information, we set out to see if we could uncover a number that we suspect are closet index funds. To qualify, a fund had to have at least a 5-year track record and could not be a real index fund. In our study, we ranked funds based on their “R-Squared” and Correlation. R-Square is a statistical measure which shows how much of the fund’s movement can be explained by the movement of its benchmark. It ranges between 0 and 100, and the higher the number, the more of its movement is based on the index, rather than the manager. In other words, the higher the number, the more likely that the fund was engaging in closet indexing.

Correlation is a measure which shows how two funds move in relation to each other. Correlations will range between -1 and +1 where -1 indicates that the two funds move in the exact opposite direction, while +1 means that the two funds will move in the same direction. Again, the higher the correlation, the more likely that closet indexing is involved.

Bottom Line: If you are able to separate the true active managers from the closet indexers, you will have a much better chance at identifying funds that have the potential to deliver returns that are much different than the index. Looking at a fund’s R-Squared and correlation can be helpful in identifying these funds. For truly active management, you will want to avoid funds that have a high R-squared as those funds are the ones that are most likely to be the closet indexers. R-squared cannot be viewed in isolation as it is not an indication of quality. Instead, you will first want to identify high quality funds, managed by experienced, disciplined management teams who use a very sound, repeatable investment process. Then, you can look at the likelihood that they are engaging in closet indexing. Combined, this should help you find the funds that have the greatest chance of outperforming over the long term.