Closet indexing continues to flourish in mutual fund land (and bring down average performance)
| Nov 29th, 2010 | Filed under: Academic Research, Retail Investing, Today's Post | By: Alpha Male |
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The stated aim of most hedge funds is to produce alpha. In a sense, hedge funds are refined expressions of active management. But hedge funds don’t have a monopoly on alpha-generation. Although mutual funds deliver large portions of market beta, some mutual funds are more active than others. So it can be useful to examine the differences between active and passive mutual funds in order to better understand the differences between (prominently active) hedge funds and (relatively passive) mutual funds.
Some mutual funds allege to be active, but their performance seems to track equity indices pretty closely. So are these managers B.S.-ing their clients or are they really making active bets? It turns out they can make a large number of active bets on individual securities, but if those active bets are randomly distributed across all stocks, they can cancel each other out and leave investors with an obfuscated index fund. Conversely, a manager might make very few active bets on individual securities but have them all occur in, say, two specific sectors. If the manager overweighs every tech name in their portfolio, the aggregate dollar value of those active bets can be modest, but the effect on the overall portfolio can still be significant. In other words, all of their active bets are pulling in the same direction (the tech “factor”).
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Interesting article and not unsurprising, but there are some flaws in it…or at least the way it is presented. (Caveat that I haven’t actually read the paper yet.) First, what is the benchmark against which the tracking errors and active share are calculated? If it is the S&P 500 across the board, then that is just plain foolishness and ignores the realities of the mutual fund world. Most of the 1,380 funds are likely not benchmarked to the S&P 500. Should a small cap fund be measured against the S&P? I hope most here realize the answer is no. So, only if the active share and tracking error are measured against the proper index are this data even remotely reliable.
Second, the bar chart is very interesting. If I’m reading it correctly, funds with high active share AND high tracking error underperform on average. Hmmm. But the broad category of high active share outperforms. Does this mean high active share and medium/low tracking error does that much better? It seems to indicate this is true, but someone can correct me. Is it that inconceivable that highly active managers might use good risk management systems to lower their vol vs. the index? (i.e., lower their tracking error). After all, TE is obviously not a good predictor of alpha in and of itself. If I was a highly active manager, and I wanted to get on 401k platforms, etc, where the big money comes in for mutual funds, then absolutely I would do what I could to maintain my level of “activeness” and lower my tracking error, thereby increasing my Information Ratio. IR is what every CIO and fund consultant out there wants, and it’s been shown to be a good tool. Just because a fund has high active share and “only” a 6% tracking error (which isn’t low, by the way) does NOT mean it’s a closet indexer…just that they use good risk management to keep the vol vs. the index at a reasonable level.
Anyway, enough for me. Am I missing something here?
Luke in the paper he discusses benchmarking and the funds are not all bench marked to the S&P 500.
The only way an active manager can add value is by deviating from her benchmark index
The way I understand it is tracking error measure systematic risk the volatility of the fund not explained by movements in the fund’s benchmark. Active share measures the percentage of the fund that differs from the benchmark; so you can have a fund with high active share and low tracking error( The two measurers are positively correlated) you get a concentrated fund if it takes both active stock selection and has high tracking error. In the paper how active management shows up depends on one key question: do the active positions have exposure to systematic risk? The data supports stock picker’s performance over tactical allocators.
The last comment has me confused, as defined in the paper closet indexers have lower active share and lower TE, plus the closet indexes charge fee as if they are active managers. An active manager has high active share and low TE.
Daniel,
Thanks for the reply. Tracking error is the standard deviation of the fund’s excess returns versus the index. It is usually measured on either a monthly or quarterly basis. So, if a very active stock picker (high active share) has consistently outperformed the index over the time period measured, the tracking error would be quite low even though the fund isn’t anywhere close to a closet index. So you just have to be careful with tracking error. Many people equate lower tracking error with lower potential for alpha. And while that may be true on an average basis, many funds have shown the ability to create very nice alpha versus the appropriate index and do so with a low/moderate tracking error because of the risk management approach that they take.
The last comment has to do with the specific comment in the article above: “Curiously, many highly active funds seem to produce markedly lower tracking errors; these are the ubiquitous “closet indexers” and they only pretend to be active.” Closet indexers, to your point, are those with low active share and low TE. High active share and closet indexer are mutually exclusive in my mind. If the fund manager uses risk management to keep the tracking error from being too high, but yet the active share is still very high, is that a closet index? Not a chance. Just beacuse the R^2 might be higher doesn’t really mean anything except your volatility against that index is lower, which for most people, isn’t a bad thing if you are still getting the stock picking.