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”).
You might call the first manager a “stock-picker” and the second manager a “factor-bettor.” But which is better? Which provides higher, more consistent returns?
A study by Yale’s Antti Petajisto of US equity mutual funds released in October provides some insight here. If you were an AAA reader back in August 2006, you may remember this post about Petajisto’s earlier work with Yale colleague Martijn Cremers. At that time, we recommended that if you read only one academic paper in 2006, that ought to be the one. The new paper makes several refinements to its earlier cousin. Most importantly, the new paper includes data up to the end of 2009 while the previous paper used data up to the end of 2003.
Petajisto uses the concept of “active share” to determine the extent to which a fund is a stock-picking fund. Readers of Cremers and Petajisto’s paper will recall that this refers to the percentage of the fund’s security weightings that differ from the weightings of those in the index.
Naturally, there is a positive relationship between active share and the resulting tracking error of the fund, that is the deviation from the index returns. The greater the active share, the greater the divergence from the index. The table below from the paper makes this point by showing the active share and resulting tracking error of 1380 funds in the study. When you look across tracking error buckets from low (0-2%) to high (14%+), you see a monotonically rising mode to each distribution of active share. The lowest tracking error was logged mainly by funds with a 0-10% active share, ie. index funds. The highest tracking error (14%+) was logged mainly by funds with an 80-100% active share.
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. They even act like they’re active by taking active bets. But at the end of the day, they deny the result: an approximation of the index at a much higher cost than the real thing. Or, as Petajisto says,
“This is of course the opposite of what investors are paying active managers to do, since investors can always buy a cheap index fund if they want to reduce volatility relative to the index. […] 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. If a fund has an Active Share of 33%, this means that fund-level annual expenses of 1.5% amount to 4.5% as a fraction of the active positions of the fund.”
This can be interpreted as a loose reference to the thesis of Ross Miller’s seminal Journal of Investment Management article on the true cost of active management.
Petajisto also channels Miller when he uses Fidelity’s Magellan fund as an example of how active share can change depending on who is managing the fund. He laments that Magellan’s active share “plunged” soon after Robert Stansky took over management in 1996. The result, reports Petajisto is that “performance suffered during this closet indexing period.” Although, he says, it was “not disastrous performance. And just as a note, Petajisto is charitable compared to Miller, who analyzed the effective fee for active management of Magellan under Stansky and wrote a paper on it called Stansky’s Monster: A Critical Analysis of Fidelity Magellan’s ‘Frankenfund’.
The proportion of funds that can be described as “closet indexers” (active share 0-60%) rose dramatically in the 1980’s and 1990’s. But did that trend continue? The chart below from the paper shows that active management actually staged a modest comeback when markets bottomed-out earlier this decade. But it rose again to all time highs by the end of last year.
So which kind of fund performs better? As you might guess, it’s the stock pickers. The chart below, based on data in Table 6 of the paper, shows the benchmark-adjusted returns of each type of fund (high, medium and low active share, plus a couple of variants):
We wondered if stock pickers or concentrated funds were also more consistent than closest indexers since their stock picking skills shouldn’t really wax and wane with the markets.
It turns out that concentrated funds showed what Petajisto calls “remarkable persistence” in their returns. In other words, last year’s winners are likely to be winners again. Conversely, he found that only the closet indexers didn’t show any return persistence. This seems to fly in the face of the efficient markets hypothesis.
In the end, Petajisto’s conclusion reads like the alpha/beta separation philosophy of this website:
“When selecting mutual funds, they should go with only the most active stock pickers, or combine those funds with inexpensive index funds; in other words, they should pick from the two extremes of Active Share, but not invest in any funds in the middle.”
It’s not a huge stretch to move beyond stock picking mutual funds and include long/short equity hedge funds in this analysis. In Cremers and Petajisto’s earlier paper, they noted:
“…the Active Share of a hedge fund can significantly exceed 100% due to its leverage and net short positions in individual stocks.”
So this analysis suggests that long/short strategies, whether in a mutual fund or hedge fund context, may indeed be a superior form of investing.