Can active funds beat passive solutions? This little-known statistic might provide some insight.

Dear Shareholder,

If you’re a fund investor, you’ve probably heard a lot over the past two years about the debate between actively managed mutual funds and passive products, such as index funds and ETFs. Behind that debate is another question: Are active managers worth their fees? Why or why not?

A few months ago, my esteemed colleague Bryan Hinmon made the case for active investing in an article for our website, www.foolfunds.com. (You can find it here: https://www.foolfunds.com/insights/the-case-for-active-investing/). I highly recommend you take six minutes and read it (after you’re finished here).

I can’t possibly make the case more eloquently or thoughtfully than Bryan has. But as an amateur investor like you, I can tell you why I own actively managed funds. It comes down to this: I deserve better than average.

The argument in favor of passive investing goes like this:

  1. Most actively managed funds don’t beat their benchmarks.
  2. Why pay more for less in performance, when you can buy an index fund or ETF and match the market’s performance?

I’ll admit, I can see the logic there. If you can’t beat ’em, join ’em.

Certainly, there’s a place for passive in any portfolio, including mine. But the thing is, I’m not willing to concede defeat across the board and settle for average, whatever-the-market-does-is-fine-with-me performance.

It’s very easy for your brain to turn the statement “most actively managed funds can’t beat the market” into “none of them can,” or “so few can that it’s not worth looking for them.”

I suggest we take a closer look at the data. According to Jim Atkinson of Guinness Atkinson Asset Management, “for the 15-year period ending June 30, 2017, 35% of actively managed equity funds outperformed their benchmark.” Over the 5 year period, that number is 31% and over 1 year, 43% beat their benchmarks. And that’s net of fund fees! And if you strip out U.S. equity funds for large caps, where the market is most efficient and it’s harder to outperform, the number jumps to 41%.

That could be viewed as a 1-in-3 chance of finding a benchmark-beating manager. I don’t know about you, but I’m willing to take those odds -- especially because I think I can improve them with a little research. Allow me to explain.

Cleaning out the closet indexers

The way I see it, there is one guaranteed way for an active fund to underperform its benchmark (or a passive fund or ETF that tracks that benchmark): by owning most of the holdings of the benchmark and then charging a high management fee. You simply can’t perform better than your benchmark if you don’t vary from it.

Funds that do this are called “closet indexers,” and there are a remarkable number of them out there. A study by K.J. Martijn Cremers and Antti Patejisto of Yale in 2009, detailed in their paper How Active is Your Fund Manager? A New Measure that Predicts Performance, found that nearly a third of actively managed U.S. mutual funds are closet indexers. So the logic follows that you could significantly increase your odds of finding benchmark-beating active funds if you can find the closet indexers and take them out of the equation.

Fortunately, those smart researchers at Yale devised a measure to help us do that. It’s called “active share.” Active share measures the percentage of fund holdings that are different from benchmark holdings. So if a fund uses the S&P 500 Index as a benchmark, active share will tell us the percentage of the fund holdings that aren’t in the S&P 500. A fund with an active share of 0 completely overlaps its benchmark -- some might call that an “index fund” -- and a fund with an active share of 100 has no overlap with its benchmark. And you know, at the very least, that those active managers are doing their jobs.

But does higher active share equate to better returns? Cremers and Patejisto’s aforementioned research says yes. They studied and computed Active Share for all U.S. equity mutual funds from 1980 to 2003 and found that high active-share funds outperformed their benchmarks by 1.13% to 1.15% annually, net of fees and expenses.

I don’t know about you, but I’d say it’s worth a little bit of work and thought for a chance at doing better than average.

You’ll have to dig a little to find a fund’s active-share score. Morningstar doesn’t provide it, so you’ll have to go to the fund’s website and poke around some more. You’ll probably find it on the fund’s fact sheet.

At Motley Fool Funds, we are pretty darn proud of our active-share scores. They’re all in the mid-90s, and you can find our active share scores in our “Fund Fact Sheets” on our website at www.foolfunds.com. More importantly, that number is a sign to our investors that we’re doing our jobs and earning our fee, because we know if you’re investing with us, you aren’t willing to settle for average.

Thank you, as always, for putting your trust in us. My team and I will continue to work hard to earn and deserve that trust every day.

 

Foolish Best,

Denise Coursey

President, Motley Fool Asset Management

 

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