Many believe pooled funds do not outperform their benchmarks over the long term. In fact, Forbes conducts a semi-annual study that seems to confirm this.
But most studies of this nature are skewed because many funds that claim to be actively managed are actually closet indexers and are not materially different from the benchmark index. When this is the case it is virtually impossible for it to outperform the benchmark after accounting for management fees and other expenses.
To outperform, the fund’s composition must be materially different from the underlying index.
Consider a study conducted by professors K. J. Martijn Cremers and Antti Petajisto at the Yale School of Management that backs this theory. They developed a concept called Active Share, which measures the fraction of a portfolio that deviates from the benchmark. They used this metric to identify closet indexers and isolate the performance of truly active managers.
Their study found that roughly a third of U.S. mutual funds claiming to be actively managed actually follow a passive style and overlap their benchmark indices, while only a quarter of active funds are truly actively managed.
Not surprisingly, the study also found smaller funds were more often identified as having a higher Active Share and vice versa. This reflects the liquidity constraints that larger funds face, which limit a fund’s ability to hold large positions in stocks that don’t have large market capitalization. The research also found a high Active Share is positively correlated with fund outperformance.
Of course just being different from the benchmark index may be a necessary condition for outperformance but is not a sufficient condition.. Regardless of a manager’s skill, a portfolio with a high Active Share is likely to outperform the index over some periods and underperform in other periods through random chance alone. To identify the potential for long-term outperformance, it is important to separate the skill of the manager from random chance.
To identify the potential for long-term outperformance, you have to separate the skill of the manager from random chance.
As anyone who has ever played roulette can attest, luck can often skew the results across a small data set. However, with a large data set, skill tends to skew the results and luck becomes a significantly less important determinant in the outcome, notes Michael Mauboussin, chief investment strategist at Legg Mason Capital Management.
This suggests a long track record is helpful in identifying managers who have the skills to outperform. The length of the evaluation period depends upon the process employed by the portfolio manager. A high-frequency trading strategy that generates a lot of performance data over a short period of time can be evaluated over a shorter period than a buy-and-hold investment strategy.
Persistence and mean reversion can also offer clues as to whether luck is shaping the outcome. When it’s up to luck, results will revert to the mean more quickly. The longer the results deviate from the mean, the more likely the outcomes are a result of skill.
Another element Mauboussin emphasizes is the importance of process in evaluating outcomes, as well as improving them. A consistent investment process can be evaluated over a shorter period of time than one that’s in constant flux. Another side effect of a consistent process is that, when a process is followed repeatedly, managers tend to increase their skills.
One of Mauboussin’s conclusions from his work on this subject is long streaks of outperformance in fund results occur more frequently that what luck alone would predict. This supports the study from Yale. Together, these studies contradict some conventional wisdom, but should hearten the fund investor.
Prior to helping found Agilith Capital, Andrea Horan was a founding partner at Genuity Capital Markets where, as a member of the Partners Committee and Director of Research, she built and managed a department of 15 analysts. She has been engaged to speak at a number of industry events, contributed to investment publications on the subject of media investments and provided expert advice to the CRTC and the Canadian Federal Government.