Trapped in the closet: when an 'active' fund isn't that active at all

March 7, 2017

The perennial issue of underperformance among active funds reared its ugly head again with a recent Financial Conduct Authority (FCA) report into the sector.

While it's hardly a revelation at this point that many active managers may not have the skill to beat the market over the long term, the report also highlighted the importance of another, lesser-known metric - the fund's 'active share ratio'.

Investors looking for decent returns would do well to pay more attention to this figure when selecting funds.

The natural assumption when you first start investing is that all actively managed funds, whatever their aims, are in one way or another sincerely trying to beat the market, even though some end up failing by making the wrong calls.


However in reality some active funds don't stray far from what an equivalent passive tracker would hold - and thus don't even try (or try as hard) to beat their benchmark.

There's a big difference between paying someone a fee to try, but fail, and paying a fee to someone who then doesn't even try at all. Enter the 'active share ratio' - which is essentially a measure of exactly this.

Take the weight of each stock in a portfolio minus the weight of that stock in the fund index or benchmark - the active share equals one half of the sum of the absolute differences in the portfolio and index stock weights, and will range between zero (total tracker) and 100 (a portfolio devoid of any index stocks).

It's a snapshot of the extent to which a fund tries to beat (or is simply doing something different from) a benchmark by deviating from it.

The worst of those funds with a low active share ratio are what are often called 'closet trackers' - and many regulators are starting to see them as a major problem.

The FCA report is fairly stark in its condemnation of investors paying 'active prices' for products that simply take small positions on either side of the benchmark, where investors would getter better returns by simply switching to an equivalent passive.

A European Securities and Markets Authority report last year found that as many as one in six active funds across the continent could be 'closet trackers'- which it defined as funds with an active share ratio of 60 or less.


But many investors also don't appreciate just how much variety there is above this point as well. A fund with an active share ratio of 70 is selling a very different investment prospect to one with 98. In a way it's about risk: to what extent do you want your manager to go against the crowd?

Many investors who invest in active funds do so precisely because they have an appetite for risk, and want returns better than those they'd expect to get from passive vehicles (which already do a fine job of tracking markets).

One tried-and-tested way of achieving outperformance, for instance, is to have the skill and courage to buy into stocks when they are unfavoured, and exit while things are looking good. This cannot be achieved by sticking close to benchmarks.

For example, Cavendish's strategy is entirely centred on a stock-picking approach. The aim is to buy shares that are attractively priced with a view to long-term growth and then take profits once potential is achieved.

This is an inherently counter-cyclical strategy - it doesn't try to track the cycle, it tries to break free of the cycle in order to capture value.

This is why the Cavendish Opportunities fund has a persistent active share ratio of 90+, usually closer to the upper 90s. This is not achieved by design - it's an inevitable by-product of what the firm perceives to be a common-sense method of investing.

At the end of the day, however the active/passive debate evolves, there will always be sophisticated investors with a higher-than-average risk appetite, and as such there will always be a place for the very best active managers that can still consistently outperform benchmarks.

For investors on the hunt for these funds, it's always worth taking a look at a fund's active share ratio in addition to other more conventional metrics.

Paul Mumford manages the Cavendish Opportunities, Cavendish UK Select and Cavendish AIM funds (picture credit: David Harrison).

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