For years a debate has raged over whether it’s better to deliver market returns through passive investment management or to try to beat the markets through active management. The question however shouldn’t be ‘passive vs. active’, but how much investors are paying for the active part of their portfolio and whether they are getting value for their money.

When it comes to active management, fund managers add value by selecting investments that are different from a benchmark index. Mirroring the benchmark doesn’t justify active management fees. But how can you measure whether a fund manager is truly active?

Introducing Active ShareA new measure called Active Share is an important piece of the puzzle. Co-developed by Martijn Cremers, professor of finance at the University of Notre Dame, Active Share compares the holdings of a fund to the holdings of a benchmark. The more a fund’s holdings differ from the benchmark, the higher the Active Share.

This measure is critical because, beyond helping to identify truly active managers, Cremers’ research has linked Active Share to higher performance. In a 2009 study1 of U.S. equity funds that looked at the period between 1980 and 2003, Cremers and Antti Petajisto found that, on average, portfolios with a high Active Share beat their specified benchmarks by 1.13% to 1.15% per year. In contrast, funds with a low Active Share, on average, underperformed their benchmarks, returning -1.42% to -1.83% per year after expenses.2

A subsequent 2011 study1 by Cremers, Miguel Ferreira, Pedro Matos and Laura Starks looked at the performance of equity mutual funds from multiple countries

between 2002 and 2007. In that paper, on average, funds with an Active Share greater than 90% outperformed their benchmarks by 3.64% after expences; funds with an Active Share between 60% and 90% outperformed by 1.63%, and funds with an Active Share less than 60% underperformed by 0.13%.

The trend is clear: High Active Share tends to correlate with benchmark-beating performance.

The Canadian landscape

What are the numbers in Canada? For his analysis of our market, Cremers divided Canadian equity funds into three categories:

1) Highly active funds with an Active Share above 80%

2) Active funds with an Active Share between 60% and 80%

3) Closet index funds with an Active Share below 60%

Among Canadian equity funds benchmarked to the S&P/TSX Composite Index, approximately 10% are highly active, 20% are active and 70% are closet indexers. That makes finding truly active funds even more of a challenge for Canadian investors than for U.S. investors. South of the border, among funds benchmarked to the S&P 500 Index, approximately 20% are highly active, 30% are active and 50% are closet indexers.

Cremers also examined a smaller pool of the largest 20 Canadian equity funds, excluding index funds, against the S&P/TSX Composite Index. These are the “big 20,” each one responsible for between $1 billion and $9 billion in assets under management.

These funds had an average Active Share of just 57%. Two of them had an Active Share above 80% and another six had an Active Share between 60% and 80%. The majority – 12 out of 20 – were closet indexers.

Beyond Active Share

Active Share is one factor in helping to determine benchmark-beating performance over time, but Cremers says there are three other qualities that contribute to a manager’s ability to outperform.

Skill

Skill is the translation of security selection into persistent, superior performance over the long run, as well as the effective management of overall portfolio risk.

Conviction

Conviction is having the fortitude to follow through on an idea, the courage to be different from the index and your peer group, and the humility to make portfolio course corrections when necessary.

Opportunity

Opportunity incorporates the manager’s ability to be flexible-managing fund size, limiting any constraints, and dealing with security illiquidity are critical components.

A New Measure of Active Management

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Identifying active mangers’ who add value through skill, conviction, and opportunity can help bolster the value you’re already providing to clients. Below is a list of considerations as you evaluate the funds that you’re using in your business.

START THE CONVERSATION

Here are three ways you can start a discussion and get your clients thinking about the importance of active management:

I believe investors who pay for active management should get active management – and now, with a tool called Active Share, there’s a way to assess how active a fund manager is. I use it in my practice to make sure my clients are getting their money’s worth.”

I use my experience to help you pick funds that are in the best position to outperform over the long term. Three things I look for in a fund manager are skill, conviction and opportunity. Let me explain why.”

Truly active fund management can make the difference between benchmark-trailing and benchmark-beating performance. I use several criteria to select the best funds for your portfolio. These include Active Share and evidence of a manager’s skill, conviction and opportunity.”

EVALUATINGACTIVE

MANAGERS

How different is the portfolio from its benchmark? What is its Active Share?

What is the fund’s track record of outperformance after fees?

How does the fund manage overall portfolio risk?

How has the fund demonstrated commitment to its strategy through all market cycles? How has it demonstrated an ability to make portfolio course corrections when an idea doesn’t work out?

What is the turnover rate and how many holdings are in the portfolio?

How large is the fund? Does it have the flexibility to take advantage of attractive investment opportunities as they arise?

What kinds of constraints are faced by the fund which could limit the decision-making ability of the manager?

Putting it into Practice

1 A recent U.S. study found that, on average, funds with a high Active Share beat their specified benchmarks by 1.13% to 1.15% per year after expenses.

2 The same study found that, on average, funds with a low Active Share underperformed their benchmarks, returning -1.42% to -1.83% per year after expenses.

3 In the U.S., about 50% of funds benchmarked to the S&P 500 Index are closet indexers.

4 In Canada, about 70% of funds benchmarked to the S&P/TSX Composite Index are closet indexers.

5 Just eight of the 20 largest “actively managed” Canadian equity funds are truly active.

ANSWER CLIENT QUESTIONS

Here are suggestions on how to reply to commonly asked questions:

MAKE THE CASE

Use these five quick facts in client communications1:

AQQ: Why is Active Share important to me as an investor?

A: Active fund managers can add value by selecting investments that are different from a benchmark index. Active Share compares the holdings of a fund to the holdings of a benchmark, so it’s a measure of how truly active a fund manager is. It’s important because a large U.S. study found that high Active Share correlates to outperformance – so, on average, and after expenses, funds with higher Active Share scores outperformed funds with lower Active Share scores.

Q: Let’s say one fund has an Active Share of 80% and another has an Active Share of 78%. Should I always go for the higher number?

A: Not necessarily. Active Share is an important way to evaluate whether a fund is actively managed or not – but other factors are important, too. These include manager skill, conviction and opportunity.

Q: How can I tell if a fund has the potential to outperform?

A: First, you can compare the fund’s holdings to its benchmark index. The more variation there is, the more actively managed the fund is and, therefore, the more potential it has to outperform. But that’s not the whole story. Look for persistent superior performance over the longer run, which indicates manager skill. Look for trim portfolios with a relatively low number of holdings, which indicates manager conviction. And look for a defined mandate without too many constraints, which gives the manager the opportunity to beat the fund’s benchmark.

Q: What do you do to make sure the funds in my portfolio are truly active?

A: I’ve developed relationships with managers who have the qualities necessary to deliver benchmark-beating performance: Active Share, skill, conviction and opportunity. I’ve asked them tough questions and evaluated their answers.

1 The 2009 study titled “How Active Is Your Fund Manager? A New Measure That Predicts Performance” by K. J. Martijn Cremers and Antti Petajisto, and the 2011 study titled “The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees and Performance” by Martijn Cremers, Miguel Ferreira, Pedro Matos and Laura Starks are in no way affiliated with IA Clarington Investments Inc. The 2009 study was based on performance data of U.S. equity mutual funds during the period from 1980 to 2003, while the 2011 study used performance data of global equity mutual funds and exchange-traded funds from 2002 to 2007. Citation of these studies is intended to highlight their findings and illustrate the potential benefits of having invested in those funds that the authors define as high Active Share and should not be construed as investment advice.2 The performance data presented after fees and transaction costs are based on the fees and transaction costs associated with the U.S. equity funds that were used in the study over the specified time period. Various differences exist in the fees and transaction costs for different types of mutual funds and between U.S. and Canadian mutual funds. In particular, management fees and expenses could be significantly higher for Canadian mutual funds. Higher fees and/or transaction costs could have reduced returns for some funds and even resulted in funds underperforming their respective benchmarks.

Dealer use only. The statements and claims made in this brochure are intended to illustrate the finds of Mr. Cremers academic research “The Mutual Fund Industry Worldwide: Explicit and Closet Indexing Fees and Performance” and should not be construed as investment advice. This brochure is not intended to promote investment in any specific funds. IA Clarington Funds and IA Clarington Target Click Funds are managed by IA Clarington Investments Inc. IA Clarington and the IA Clarington logo are trademarks of Industrial Alliance Insurance and Financial Services Inc. and are used under license.

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