The investment markets are an incredibly complex world for DIY investors, but none more so than the managed fund and listed investment company sectors. Managed funds can provide important diversification and access to highly skilled and dedicated professional managers at a reasonable cost, however, there are many funds in Australia that do little but charged high fees for below average performance. This is best evidenced by the regular Standard and Poor’s analysis suggesting the majority of Australian equity managed funds underperform their index over most periods.
What this analysis excludes though, is the fact that many of these ‘active’ managers actually do nothing of the sort. So we thought it appropriate to introduce two ratios that we value when assessing professional fund managers all over the world; Active share and portfolio turnover.
As is typically the case in finance, the measure of active share was invested by two Yale professors in 2006. Active share is a holdings-based statistic that seeks to measure how different an equity portfolio is from its benchmark as well as the proportion of a portfolio that drives performance. Put simply, it measures the ‘fraction’ of a portfolio, whether your own shares or a managed fund, that differs from the benchmark, like the S&P500 or the ASX 200. An example is shown in the table below:
As you can see, active share is calculated by taking the sum of the difference between all of the holdings in the portfolio and those of the benchmark. This is then divided by 2 to avoid double counting. The result in this case being that fund has an active share of 40%, with the remaining 60% considered the passive share or replication of the index. The authors of the study concluded that an active share of 20% to 60% is actually closet indexing, whilst under 20% was as good as being completely passive.
Why is it important? Without going into too much detail, the study and several subsequent analyses found that one of the most common traits of investment managers that regularly outperform their benchmarks and deliver better than average returns to investors was a high active share of over 80%. This is reflected in their willingness to take risks and invest into higher conviction portfolios. The study summarised the conclusion as follows: “funds with the highest Active Share significantly outperformed their benchmarks, both before and after expenses, and they exhibited strong performance persistence.”
The second and more straightforward measure is Portfolio Turnover. As the name suggests, it records how frequently the assets within a fund or portfolio are bought and sold. It is calculated simply by dividing the total amount of new securities bought or sold during a period by the net asset value of the fund.
As you would expect, the rate of portfolio turnover is important for investors to consider, as high turnover will generally result in higher fees due to the level of daily management and brokerage required. They also typically incur higher capital gains that must be distributed to investors.
Similarly to Active Share, those funds with lower portfolio turnover have tended to outperform their benchmarks and do so more consistently over the long-term. This is generally due to the managers having higher conviction in their holdings, not unlike a buy and hold investor.