The value of (truly) active investment

[December 04, 2014]  By James Saft

(Reuters) - If you are going to go with active management you perhaps ought to go all out.

The more your mutual fund trades, the better it will do, particularly if it is small and charges high fees is the upshot of a new study. While some questions are unanswered, the active versus passive investment debate is more complex than the aggregate data showing active underperformance shows.

“We find that active mutual funds perform better after trading more. This time-series relation between a fund's turnover and its subsequent benchmark-adjusted return is especially strong for small, high-fee funds,” the authors of the study, Lubos Pastor of the University of Chicago and Robert Stambaugh and Lucian Taylor of the University of Pennsylvania, write. (http://papers.nber.org/tmp/35585-w20700.pdf)

“These results are consistent with high-fee funds having greater skill to identify time-varying profit opportunities and with small funds being more able to exploit those opportunities.”

Presuming that funds trade more when they see better opportunities, the study sought to relate trading activity to subsequent performance, looking at data from more than 3,000 active U.S. equity mutual funds from 1979 to 2011. The findings were strong: a one-standard deviation increase in turnover brings with it a 0.65 percentage point per year increase in return for the typical fund. What’s more, this increase is greater among smaller funds and those which charge higher fees.

Much of this is consistent, at least superficially, with earlier studies which find diminishing returns to active management among larger funds, and, indeed, as the industry itself gets larger. This may be because larger funds, and a larger industry, are less able to exploit mis-priced stocks when they see them.

So it stands to reason that smaller funds are better able to put on trades of a size to make an important difference to their returns when they see inefficiencies. Further, the more good trades they see, the more they trade, thus driving the correlation between activity and subsequent returns. Further yet, to the extent that skill exists, it also seems to make sense that managers are able to extract extra compensation for it in the form of fees.

To be sure, this study isn’t an argument, in and of itself, for going all-in on active management. What it does seem to indicate is that there is a value to active management and that investors should be careful and vigilant about what they are paying for and why. This, in its own way, is no different than the case with types of quasi-passive investment management now popular.

AN INDEXER BY ANOTHER NAME

All of this is also consistent with a 2013 paper which found that the most active stock pickers actually outperform the market, even taking into account fees and transaction costs. The study, by Antti Petajisto of New York University and fund manager Blackrock, actually defined 'active' slightly differently, measuring funds not by how often they trade but by how much they deviated from their underlying benchmark.

The most active group in Petajisto’s study beat the index by 2.61 percent annually and managed to outperform by 1.26 percent a year even after fees. Those funds, in other words, are taking on more risk relative to their comparative performance, but are getting more in exchange.

It is important here to consider the issue of career risk. Since fund managers survive and are paid based on their performance against a benchmark, they, depending on their abilities and temperaments, tend to adopt different strategies. One strategy is to make bigger bets. The advantage for clients is that this approach will tend to unmask a lack of skill, leading to a short career.

Other managers, either because they are risk averse or less talented, turn into what are sometimes called 'closet indexers,' hugging closely to an index so as to minimize the risk of career ruin. This can be especially tempting when the fund they manage has grown to a considerable size. Then they face a dual problem: the risk of losing a lucrative gig and a lack of good, large, liquid investment opportunities. The result can look a lot like an index fund, but with very high fees.

“The problem is that closet indexers are very expensive relative to what they offer,” Petajisto writes. “A closet indexer charges active management fees on all the assets in the mutual fund, even when some of the assets are simply invested in the benchmark index.” (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1685942)

On his criteria, about one third of mutual fund assets in 2009 were with closet indexers which were making only small deviations from the index.

The active versus passive debate is far from over, but with evidence of value being created by both expensive and very cheap funds, the middle of the pack looks like the place to avoid.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at [e-mail] and find more columns at http://blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

[© 2014 Thomson Reuters. All rights reserved.]

Copyright 2014 Reuters. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.