Rebecca Harpaz, 43, owns three franchise outlets of a major fast-food restaurant in Hamilton, Ont. Prior to 2008, she paid little attention to her investments, leaving everything to her advisor. The crisis changed that. Like many, her portfolio’s recovered; but the experience convinced her she shouldn’t be in the dark about her life savings. Rebecca recently came across studies showing a significant number of people billed as active managers are, in reality, closet indexers.

She remembers her advisor explaining the benefits of actively managed funds, and that the extra fees were worth it. At the time, she simply went along with his recommendations, so her portfolio’s loaded with such funds. Her worry: If she has closet-indexer funds, she’s paying hefty active fees for passive performance. She wants to know what her advisor’s sold her.

The problem

Rebecca tells her advisor she wants evidence her funds are truly active. But the meeting’s a disappointment: he speaks in generalities and gives toned-down versions of fund companies’ marketing pitches.

She takes another tack. She brings her portfolio to a competing firm and asks for an assessment, making it clear her top concern is identifying closet indexing.

The experts

Virginia Au

Virginia Au

vice-president and portfolio manager, Trimark Investments, Toronto

Donald K. Emond

Donald K. Emond

senior financial advisor, Assante Wealth Management, Cobourg, Ont.


Degree of difficulty

6 out of 10. The main challenge in cases like Rebecca’s is the initial transfer. If the portfolio were loaded with DSC funds or would trigger heavy capital gains, it could delay the overhaul for years. Emond says the process of rebuilding her portfolio with high-active-share funds is more straightforward.

The method

Virginia Au, vice-president and portfolio manager at Trimark Investments in Toronto, says the best metric for rooting out closet indexers is active share, developed in 2009 by then-Yale professors K. J. Martijn Cremers and Antti Petajisto.

The metric is a score expressed as a percentage. For instance, an equity fund that matches the index perfectly has an active share of 0%; a fund with a score of 72% is 72% different than its benchmark. Petajisto pegs the closet-indexer cut-off at 60%—anything lower and the fund isn’t truly active.

Au says traditional measures of active management, including turnover and tracking error, paint an incomplete picture. High turnover means the manager’s buying and selling a lot of names, but the fund doesn’t necessarily look different from the index. And this activity suggests the manager’s more trader than stock picker. The latter, says Au, requires bottom-up analysis of each stock—a lengthy process. If a lot of names move in and out, chances are the manager’s not heavily vetting them, and instead is shooting for lots of small gains on short-term calls.

Tracking error tells you the difference between the fund’s return and the benchmark. “But you’re just looking at the end result, not how it got there,” says Au. That’s important because the results could be due to luck.

Active share, she explains, takes the how into account. It analyzes each name in the fund and assigns an overall score. “If a fund manager is a stock picker, it should be a high number,” says Au. She tells advisors her scores when she meets with them.

Calculating active share is highly complex. Here’s the formula Petajisto and Cremers developed:

Active share formula

Advisors can ask fund companies to provide them with active share scores for managers.

Don Emond, senior financial advisor at Assante Wealth Management in Cobourg, Ont., says he only works with managers with active share scores, since he can’t otherwise tell if a manager’s earning his or her fees. He doesn’t consider funds with less than 75% active share.

Closet indexing is the practice of staying close to the benchmark index while claiming to be an active manager and usually also charging management fees similar to truly active managers.”

– Antti Petajisto, Financial Analysts Journal, vol. 69(4), 2013.

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It is not often that I see an advisor fired for tripling the value of the S&P 500 [since March 2009].

I think the investor could have done far worse than a “three bagger”.

“If it beats its benchmarks net of fees, she will continue with the high-active-share strategy. If it doesn’t, she’ll consider a more passive approach.”

A investment advisor should never allow themselves to be caught in the performance trap of promising performance returns or promises of beating the index 100% of the time.

If you do, invariably you will lose the client and this client has said she will leave if necessary.

Metrics, formulas, back-tested models, etc. as we all know – cut both ways.

In my view, in the new paradigm, the client pays a fee to you to manage the assets. If the adviser wishes to use passive investments in the portfolio and talks the investor out of a -57% S&P 500 loss on March 9, 2009, the adviser has earned his or her fee many times over. Or the adviser can choose ‘stars” or A+ funds, or the picks of his favorite newspaper columnists.

There are of course innumerable ways of managing money but really the spotlight is on the adviser earning their keep and providing the value-add.

Focusing too much on just product puts the spotlight on the product – not on you as it should be.

It is hard to judge based on this one article but the client’s loyalties are to the numbers, not to her new adviser.—

Tuesday, Sep 30, 2014 at 12:32 pm Reply