The Evidence-Based Investor

Tag Archive: Active Share

  1. Measly fines for closet index funds do nothing to stop them

    Comments Off on Measly fines for closet index funds do nothing to stop them

     

     

    By ALEX MOFFATT

     

    Ireland’s Central Bank issued a press release in early November about a fine it had imposed on an investment company. The company, Mercer Global Investments Management Limited (MGIM), is not a big name in the investment world and the fine, of €117,500, is trivial in an industry that routinely deals in billions. It sounds like a small, local event. So why should anyone beyond those whose money was being invested by MGIM care? Because, though minor in itself, it provided yet another glimpse of a scandal through which millions of investors all over the world are unknowingly being ripped off: the scandal of closet index funds.

    Index tracking is the simplest, cheapest way to invest. It’s an administrative task that requires no special investment strategies or cutting-edge research, so index funds charge exceptionally low management fees. Actively managed funds, on the other hand, tend to charge a whole lot more on the basis that they employ expert money managers to do research and implement supposedly market-beating strategies.

    However, a disturbing number of funds that claim to be actively managed appear to be doing little more than tracking an index, while still helping themselves to hugely inflated management fees. This is what closet indexing means.

     

    Tip of the iceberg

    Returning to the case of MGIM, it admitted that between July 2011 and December 2018, the prospectuses and investor information documents for five sub-funds had failed to disclose that these funds relied on an index-tracking strategy, and did not provide details of the index being tracked.

    This case is likely to be only the tip of the iceberg in Ireland. It follows from a major review, carried out by the Irish Central Bank and published in July 2019, that covered “all of the 2,550 Irish authorised UCITS funds classified as actively managed as at March 2018”.

    The findings were non-specific but raised concerns suggestive of a lot of potential closet indexing. For instance, it found that “investors were not always given sufficient or accurate information about the fund’s investment strategy”, and that when giving information on past performance, “no comparator was included so that investors in these funds were not able to determine whether the fund, irrespective of performance, represented good value relative to its benchmark”.

    It’s what economists call information asymmetry, where the buyers know far less about the product than the sellers, so buyers can easily be ripped off.

    To be clear, this is a global problem. Back in 2018, as reported by Robin Powell in an article on this website, the UK’s regulator, the Financial Conduct Authority, forced fund managers to pay £34 million to investors in closet index funds. In all, 64 funds were fined in this case, but experts felt this was only scratching the surface.

    A large study of the issue was conducted by ESMA, the European Securities and Markets Authority, that was published in 2016. It examined a sample of 2,600 managed funds for the period 2012-2014 using various quantitative measures and concluded that “between five and 15 per cent of UCITS equity funds could potentially be closet indexers”.

    That sounds conservative. An academic paper from 2015 concluded that, in Canada, about 37 per cent of assets were invested in closet index funds.

    It could be even worse than that. Back in 2015, Robin Powell cited research that found that closet trackers accounted for more than half the assets in Swedish and Polish domestic equity funds, and more than 40 per cent of assets in Canada, Finland and Spain.

     

    Spotting the cheats

    Unfortunately, investment is a complex business and there’s no easy, instant way to spot a closet tracker. The most commonly cited method of detection is known as Active Share, a measure of the extent to which a fund’s holdings deviate from its benchmark index. If there is no difference at all from the benchmark, it’s safe to say the fund is a tracker, and the degree of deviation should indicate the amount of active management.

    It’s often not a black-and-white issue. Managed funds can use indexing to varying extents. Often funds start life with a genuine, fully managed strategy but find this harder and harder to implement as the size of the fund grows. There’s a temptation as they grow to slide quietly toward indexing, while continuing to charge the same high management fees. Indeed, data analytics firm Peer Analytics concludes that more than a third of US equity mutual funds are so passive in their strategy that they “fail to merit a typical fee”.

    Despite the promise of Active Share as a measure, it’s far from foolproof (Larry Swedroe raises some serious concerns here). Detecting closet indexing unfortunately requires a lot of slow, arduous work by regulators that are unlikely to have the capacity to keep a close eye on thousands of mutual funds. If the profits from closet indexing are substantial and the chance of detection is low, the problem is bound to persist.

     

    A simple solution

    From an investor’s point of view, though, there is a simple solution: seek out a low-cost index fund and don’t put your savings in a managed fund. The low charges provide an instant gain. But what about performance, you might wonder. The attraction of a managed fund is the hope that its skilled money managers will be able to beat the market.

    But there’s little evidence to support this hope of outperformance. UK investment platform AJ Bell publishes periodic reports comparing passive and active funds, or “manager versus machine”, as it calls them. Its newly published report for 2022 finds that only 27 per cent of active funds outperformed the passive alternative in the year. That’s down from 34 per cent in 2021, and even over 10 years, only 39 per cent of active funds outperformed passive rivals.

    That means your odds of outperforming are considerably worse than the toss of a coin. Defenders of active management might argue that the secret is picking the right fund to invest in. The best money managers will surely get you the best return, right? It’s easy enough to check which managed funds have performed particularly well over the past year or two. But how worthwhile is this information?

    The Economist quotes some revealing data in this regard. It takes a baseline of the 12 months to March 2013. Suppose you picked one of the best-performing 25 percent of US equity mutual funds from that period. In the subsequent 12 months, just 25.6 per cent of those funds remained in the top quartile. To put it another way, had you picked a winning fund in March 2013, the chances are greater than 75 per cent that it would perform badly over the next 12 months. And year by year, it keeps getting worse. After two years, just 4.1 per cent of the original winning group remain in the top 25 per cent. After three years, it drops to a miserable 0.5 per cent.

    Investing success is all about long-term performance, and there is a mountain of data to show that consistently outperforming fund managers are a vanishingly rare breed. And while they fail to perform, they continue to extract hefty fees. Low-cost index investing really is a no-brainer.

     

    The message for regulators

    Meanwhile, the message for financial regulators is clear: we’ve been talking about closet index funds for years, but they aren’t going away. Consumers the world over continue to be misled.

    What investors need is a clear, concerted message from the regulatory authorities that blatant closet indexing is fundamentally dishonest and won’t be tolerated. And that means handing down much bigger fines than those imposed so far.

     

    ALEX MOFFATT is a journalist, formerly on the staff of the Irish Times and then the Irish Daily Mail and Irish Mail on Sunday. He has postgraduate degrees in American literature, journalism and politics, and he lives in Dublin.

    I learned to stay disciplined the hard way

    Why market predictions are best ignored

    Price efficiency unaffected by growth of indexing — new study

     

    FIND AN ADVISER

    Investors are far more likely to achieve their goals if they use a financial adviser. But really good advisers with an evidence-based investment philosophy are sadly in the minority.

    If you would like us to put you in touch with one in your area, just click here and send us your email address, and we’ll see if we can help.

     




     

    © The Evidence-Based Investor MMXXII

     

     

  2. Identifying winning funds ex ante: Is it possible?

    Comments Off on Identifying winning funds ex ante: Is it possible?

     

     

    By LARRY SWEDROE

     

    While there’s no longer any debate that active management underperforms in aggregate, the majority of active funds underperform every year, and the percentage that underperform increases with the time horizon studied. If an investor were able to identify the few future alpha generators, active management could be the winning strategy. The logical strategy, as is the case in almost any endeavour, would seem to be to rely on past performance. However, an overwhelming body of academic research demonstrates that the past performance of actively managed mutual funds alone does not provide valuable information as to future performance, and (as the annual SPIVA Persistence Scorecards regularly report) there is less persistence of outperformance than randomly expected. So the quest for a metric that could identify the future alpha generators ex ante continued.

    Believers in active management were offered hope with the 2009 study by Martijn Cremers and Antti Petajisto, How Active Is Your Fund Manager: A New Measure That Predicts Performance. They concluded: “Active Share [a measure of how much a fund’s holdings deviate from its benchmark index] predicts fund performance: funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence.” Unfortunately, subsequent research found problems with the conclusions drawn by Cremers and Petajisto:

    • Andrea Frazzini, Jacques Friedman and Lukasz Pomorski, authors of the 2016 study Deactivating Active Share, found that controlling for benchmarks, active share had no predictive power for fund returns.
    • Ananth Madhavan, Aleksander Sobczyk and Andrew Ang of BlackRock, authors of the 2016 study Estimating Time-Varying Factor Exposures, found that the measure of active share proposed by Cremers and Petajisto was actually negatively correlated (-0.75) to fund returns after controlling for factor loadings and other fund characteristics. Thus, they concluded that “it is not the case that high conviction managers outperform.”
    • In its November 2021 paper, Is Active Share Unattractive?, Morningstar found that since 2011 investors in high-active-share funds in all Morningstar categories had paid higher fees, incurred greater risks, and earned lower returns. While it may have provided a ray of hope at one point, as Andrew Berkin and I demonstrated in our book, The Incredible Shrinking Alpha, the markets have become increasingly efficient over time, raising the hurdles for active management.  
    • In a related 2022 study, Fund Concentration: A Magnifier of Manager Skill, Chris Tidmore found that alpha had near-zero correlation with concentration in aggregate.

     

    The quest continues

    With the evidence against active share mounting, researchers have continued their quest to find a metric that would identify, ex ante, future alpha generators. For example, Martijn Cremers, Jon Fulkerson and Timothy Riley, authors of the 2022 study Active Share and the Predictability of the Performance of Separate Accounts examined if active share combined with past performance was a predictor of mutual fund performance. Unfortunately, they found no statistically significant evidence that the combination could predict the future performance of mutual funds. And while they did find evidence that, using the double sort, they could identify separate account managers who would go on to outperform, that was true only for small stocks, not large stocks, which make up about 90 percent of the market cap. 

    Another attempt at finding the holy grail metric was made by ZhengAi He and Eric Tan, authors of the 2022 study Shared Experience in Top Management Team and Mutual Fund Performance, in which they examined the role of top management teams (TMTs) in the U.S. mutual fund industry, focusing on the shared experience (overlapping of experience) between fund managers. Their hypothesis was that TMTs illustrate synergy based on shared experience, contributing to information gathering, risk adjustment, decision-making and enhanced productivity. While they did find that high concentration and high active share were characteristics of TMTs, shared experiences did not provide information on the ability to outperform risk-adjusted benchmarks.

    In his study Portfolios of Actively Managed Mutual Funds, published in the August 2021 issue of The Financial Review, Tim Riley took a different approach to finding the holy grail of active management. Instead of focusing on individual actively managed funds, he built an optimised portfolio of actively managed funds that had recent strong performance (top 5 percent in the past 12 months) such that the information ratio (a measurement of portfolio returns beyond the returns of a benchmark, usually an index, compared to the volatility of those returns) would be maximised. The good news was that he found that the optimised portfolio did subsequently have low idiosyncratic volatility and statistically significant alphas against asset pricing models. For example, the Carhart four-factor (beta, size, value and momentum) alpha of the optimal portfolio was 2.40 percent per year (t-stat = 2.24) compared to -0.45 percent per year (t-stat = -0.33) for the equal-weighted portfolio. However, the optimised portfolio required high turnover (average monthly turnover of 47 percent), and the alpha only persisted for one quarter—though it was statistically significant only at the one-month horizon. Thus, any alpha would likely be eliminated by transactions costs, let alone taxes (for taxable accounts). 

    Not surprisingly, Riley also found that investors react to the information with a substantial flow of assets toward funds expected to have short-run outperformance. Those fund inflows could explain the short-term persistence (by creating momentum in performance) and the future lack of performance—increased cash flows increase the hurdles to generating alpha because of diseconomies of scale (increasing market impact costs). This finding is in line with the hypothesis of Jonathan Berk and Richard Green, authors of the 2004 study Mutual Fund Flows and Performance in Rational Markets: “Fund flows rationally respond to past performance in the model even though performance is not persistent and investments with active managers do not outperform passive benchmarks on average.” While Riley’s findings do support Berk and Green’s hypothesis that fund manager skill exists, they don’t provide much hope for investors using active strategies.  

     

    Summary

    Given the potential rewards, and the incentives the active management community has given their higher fees, it is no surprise that the quest for the metric that can provide the holy grail of outperformance continues. With that said, in the face of all the evidence, it is difficult to make the case that active share, active share and past performance, shared experiences or past performance combined with a high information ratio have strong, useful, predictive value in terms of future risk-adjusted outperformance. The evidence demonstrates that investors, especially taxable investors, are best served by identifying the factors to which they want exposure and then selecting the fund(s) that provides them with exposure to those factors in a systematic, transparent, replicable and cost-effective (low cost per unit of exposure) manner.  

     

    For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice.  Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth® and Buckingham Strategic Partners®, collectively Buckingham Wealth Partners.  Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. LSR-22-358

     

    LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.

     

    ALSO BY LARRY SWEDROE

    If you found this post interesting, you might also want to read these other articles that Larry has written about sustainable investing:

    The impact of ESG uncertainty on asset prices

    What does a change in ESG rating tell us about future returns?

    ESG investing: Is best-in-class the way to go?

    Can investors improve returns by reducing ESG risks?

    ESG strategies: do risk factors explain returns?

     

    CONTENT FOR ADVICE FIRMS

    Through our partners at Regis Media, TEBI provides a wide range of high-quality content for financial advice and planning firms. The material is designed to help educate clients and to engage with prospects.  

    As well as exclusive content, we also offer pre-produced videos, eGuides and articles which explain how investing works and the valuable role that a good financial adviser can play.

    If you would like to find out more, why not visit the Regis Media website and YouTube channel? If you have any specific enquiries, email Robin Powell, who will be happy to help you.

    Picture: Anne Nygård via Unsplash

     

    © The Evidence-Based Investor MMXXII

  3. Investor sentiment and mutual fund stock picking

    Comments Off on Investor sentiment and mutual fund stock picking

     

     

    By LARRY SWEDROE

     

    Research, beginning with the 2006 study Investor Sentiment and the Cross-Section of Stock Returns by Malcolm Baker and Jeffrey Wurgler, has found that investor sentiment — the general mood investors exhibit toward a particular market or asset—can be an important determinant of investment performance. Investors who exhibit relatively high sentiment tend to be overconfident and engage in excessive trading, resulting in subpar investment performance because they are trading on “noise” and emotions. Such activity can lead to mispricing. Eventually, any mispricing would be corrected when the fundamentals are revealed, making investor sentiment a contrarian predictor of stock market returns. Examples of times when investor sentiment ran high are the 1968-69 electronics bubble, the biotech bubble of the early 1980s, and the dot-com bubble of the late 1990s. 

    Baker and Wurgler constructed an investor sentiment index based on five metrics: the value-weighted dividend premium (the difference between the average market-to-book ratio of dividend payers and non-payers), the first-day returns on initial public offerings (IPOs), IPO volume, the closed-end fund discount, and the equity share in new issues. Originally, the Baker-Wurgler index included a sixth metric; however, the NYSE turnover ratio was dropped. (Data is available at Wurgler’s New York University web page.)

    Baker and Wurgler’s original work generated great interest among researchers into the role that investor sentiment plays. Their original findings have been confirmed and supported by the findings from the 2011 study Investor Sentiment and the Mean-Variance Relation, the 2012 studies Global, Local, and Contagious Investor Sentiment and The Short of It: Investor Sentiment and Anomalies, and the 2020 study Investor Sentiment: Predicting the Overvalued Stock Market, which found:

    • Investor sentiment plays a significant role in market volatility and generates return predictability of a form consistent with the correction of investor overreaction.
    • The Baker-Wurgler investor sentiment index is a reliable contrarian predictor of subsequent monthly, six-month and 12-month market returns but only during high-sentiment periods, and the economic significance is nontrivial.  
    • Broad waves of sentiment have greater effects on hard-to-arbitrage (due to greater costs and greater risks) and hard-to-value stocks (small-cap, high return volatility, growth and distressed stocks). These stocks will exhibit high “sentiment beta.” 
    • Returns to anomalies are stronger following high investor sentiment — about 70 percent of benchmark-adjusted profits from long/short anomaly strategies occurred in months following levels of investor sentiment above their median value. In addition, there was little evidence of overpricing in the long leg of anomaly portfolios.
    • Not only do local and global sentiment predict the cross-section of a country’s returns, but investor sentiment also is contagious — investor sentiment contains a market-wide component with the potential to influence prices on many securities in the same direction at the same time.

    The economic theory behind the findings is that because of the impediments to short selling, overpricing becomes more difficult to eliminate, the result being that overpricing should be more prevalent than underpricing. The reason is that limits to arbitrage result in investors with the most optimistic views about a stock being able to exert the greatest effect on the stock’s price; and their views are not counterbalanced by those of the relatively less optimistic investors, who are inclined to take no position if they view the stock as undervalued, rather than take a short position. Thus, when the most optimistic investors are too optimistic and overvalue the stock, overpricing results. In contrast, underpricing is less likely because the cross-section of views includes the views of rational investors. 

    The conventional view is that naive retail investors are the ones driving prices during periods of high sentiment, leading to overvaluations. New research calls that view into question. 

     

    Active fund managers and the role of investor sentiment

    Timothy Chue and G. Mujtaba Mian contribute to the literature on the role of investment sentiment with their June 2022 study, Investor Sentiment and Mutual Fund Stock Picking, in which they examined whether mutual fund managers’ stock picking becomes less active (i.e., deviates less from their benchmark) when investor sentiment is high. They stated: “Such behaviour, if found, suggests that fund managers become less discriminant between stocks in their information collection and trading, and can contribute to the prevalence of relative mispricing when sentiment is high.” They used a fund’s active share — the percentage of a fund’s portfolio that differs from the fund’s benchmark index — as a proxy for the activeness of its manager’s stock selection. Their data sample contained 2,245 U.S. domestic, active (non-index) equity mutual funds covering the period 1985 through the third quarter of 2009. Using two measures of investment sentiment and controlling for two measures of market turmoil (VIX, the implied volatility of S&P 500 index options, and the FEARS index), they found:

    • Actively managed mutual funds engaged in less stock picking during periods of high investor sentiment, with the average active share of mutual funds declining by an economically significant 2-3 percent at times when there is a one-standard-deviation increase in investor sentiment—institutional investors are susceptible to changes in investor sentiment, becoming less discriminating across individual stocks during periods of heightened market volatility.
    • Consistent with prior research, the impact of sentiment on mispricing was concentrated in periods of positive sentiment.
    • The negative relationship between investor sentiment and active share was robust to controlling for stock return co-movement, which is important because stock return co-movement tends to rise during periods of high investor sentiment.
    • Their findings were driven by sentiment rather than by confounding macroeconomic conditions.

    They noted that their finding that active institutional investors are affected by investor sentiment is consistent with those of the authors of the 2019 study Sentiment Metrics and Investor Demand, who found that institutional investors are net buyers (sellers) of volatile stocks from individual investors during high (low) sentiment periods (with momentum strategies explaining a significant portion of the behavior).  

    Their findings Chue and Mian led to conclude: “As mutual funds focus less on the differences between individual companies and become less active in their stock selection, relative mispricing increases and the returns on cross-sectional anomalies become more pronounced. Our results call into question the conventional view that it is only the preponderance of retail investors during high sentiment periods that allows sentiment to exert greater influence on prices.”

     

    Conclusion

    Investors’ first takeaway should be to avoid being a noise trader — don’t get caught up in sentiment, following the herd over the investment cliff. Stop paying attention to prognostications in the financial and social media. Most of all, have a well-developed, written investment plan. Develop the discipline to stick to it, rebalancing when needed and harvesting losses as opportunities present themselves. 

    A second takeaway is that actively managed funds do not provide sanctuary from overvaluation created by investor sentiment. In fact, in aggregate, they are contributing to the overvaluation — providing yet another reason to avoid using actively managed funds. That finding provides another explanation for their persistent underperformance.

     

    For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed adequacy of this article. LSR-22-328

     

    ALSO BY LARRY SWEDROE

    The relationship between the risk-free rate and equity risk premium

    Do funds with more than one manager perform better?

    The role of concentration in fund performance

    Who buys cryptocurrencies?

    How does R&D spending affect future returns?

    THE PODCAST

    Have you discovered The TEBI Podcast? You’ll find it on SoundCloud, Spotify, Apple Podcasts, Podbean or your preferred podcast provider.

    © The Evidence-Based Investor MMXXII

     

  4. Do funds with more than one manager perform better?

    Comments Off on Do funds with more than one manager perform better?

     

     

    By LARRY SWEDROE

     

    While there’s no doubt that active management underperforms in aggregate, the majority of active funds underperform every year and the percentage that underperform increases with the time horizon studied. If an investor were able to identify the few future winners by using active share as a measure, active management could be the winning strategy. Given the potential rewards, the search has been extensive — the financial equivalent of the search for the Holy Grail. 

    Unfortunately, to date, attempts have failed. Hope was offered by Martijn Cremers and Antti Petajisto, authors of the 2009 study How Active Is Your Fund Manager? A New Measure That Predicts Performance, who found that active share (a measure of how much a fund’s holdings deviate from its benchmark index) does predict fund performance. However, their findings have not held up. For example, in their November 2021 study Unattractive Share? , Morningstar found that despite exhibiting greater risk, high active share funds failed to deliver superior net-of-fee results in any category. Further, in their study Active Share and the Predictability of the Performance of Separate Accounts published in the First Quarter 2022 issue of the Financial Analysts Journal, Cremers (one of the authors of the original paper on active share), with co-authors Jon Fulkerson and Timothy Riley, did not find evidence of statistically significant persistence in mutual fund performance even double sorting by active share and past performance. Thus, the search goes on.

    ZhengAi He and Eric Tan contribute to the literature on the performance of actively managed funds with their study Shared Experience in Top Management Team and Mutual Fund Performance, published in the July 2022 issue of The Journal of Portfolio Management, in which they examined the role of top management teams (TMTs) in the U.S. mutual fund industry, focusing on the shared experience between fund managers. Their hypothesis was that TMTs illustrate synergy based on shared experience, contributing to information gathering, risk adjustment, decision making and enhanced productivity. Thus, they considered the overlapping of experience between fund managers (as a proxy for shared experience) on TMTs. They measured the shared experience in the TMTs based on the total number of overlapping years between the top two managers with the longest tenure for fund i at time t, choosing the two most experienced managers as the representation of the TMT experience on the mutual fund team because two-people teams dominated the sample. 

     Their data, from Morningstar, covered the U.S. open-ended equity mutual fund industry over the period 1992 to 2017. Accounting for survivorship bias by including live and dead funds, their sample covered 4,171 unique funds and 585,305 fund-month-level observations. They measured style-adjusted return as the difference between fund net returns and the average returns for all funds pursuing the same investment style at time t, and measured benchmark-adjusted return as the difference between fund net returns and their stated benchmark index at time t. In addition, they measured the risk-adjusted return using five asset pricing models, including the capital asset pricing model (CAPM) and the Fama and French five-factor model (beta, size, value, investment and profitability). Following is a summary of their findings:

    • Two-people management teams dominated the team-managed funds, averaging around 66 percent. However, the percentage dropped from about 84 percent in 1992 to about 56 percent in 2017. Over the period, the percentage of three-person teams more than doubled, approaching 19 percent, and the percentage of four-person teams increased from less than 2 percent to almost 11 percent — there was a trend toward having larger teams.
    • Consistent with prior research findings, expense ratios, turnover and fund age were significantly negatively correlated with fund performance.
    • Funds with higher shared experience focused on more concentrated portfolios, a smaller number of shareholdings, lower turnover, longer durations (the weighted-average length of time the stocks were held by the portfolio over the previous five years based on the quarterly holdings) and higher active share.

    While He and Tan found that higher shared experience resulted in more concentrated portfolios, Chris Tidmore, author of the study Fund Concentration: A Magnifier of Manager Skill published in the July 2022 issue of The Journal of Portfolio Management, found that alpha had near-zero correlation with concentration in aggregate. Higher active share, as mentioned, has not been found to be a predictor of future mutual fund performance either, just higher dispersions of outcomes. Thus, while high concentration and high active share are characteristics of TMTs, they do not provide information on the ability to outperform risk-adjusted benchmarks (generate alpha). On the other hand, the findings of lower turnover/longer durations should have a positive impact on performance by lowering trading costs. 

    Also of interest is that while He and Tan found that an increase in shared experience between the top two managers was associated with an increase in fund performance, they also found that team size was negatively correlated with future performance — as team size increased, there was no longer any statistically significant evidence of outperformance, failing a test of robustness that shared experiences lead to superior performance. In addition, there has been a strong trend toward increasing the size of teams.

    Another interesting finding was that, when He and Tan split their sample into three equal terciles (low, medium and high) based on the level of disruption created due to the departure of fund managers, they found that the value added of having high shared-experience TMTs disappeared. 

     

    Investor takeaway

    Viewed through the proper lens, He and Tan’s findings do not provide much hope for investors using actively managed funds. While they found that shared experiences led to higher concentration and higher active share, the evidence suggests that neither provides much if any information in terms of future performance.

    In addition, the finding that teams with more than two managers had no statistically significant outperformance limits the value to restricting purchases to just two-manager teams. However, doing so would leave investors vulnerable to a fund increasing the number of managers and running the risk of disruption if a manager leaves, as funds with disruptions showed no statistically significant outperformance.

    Further, the finding that a fund’s age was negatively correlated with performance also creates risks for investors choosing active funds because their performance tends to deteriorate over time. 

     

    For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed adequacy of this article. LSR-22-327

     

     

    LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.

     

    ALSO BY LARRY SWEDROE

    The role of concentration in fund performance

    Who buys cryptocurrencies?

    How does R&D spending affect future returns?

    Factor momentum and stock momentum

    How wealth, age and gender affect investment decisions

     

     

    FIND AN ADVISER

    The evidence is clear that you are far more likely to achieve your financial goals if you use an adviser and have a financial plan.

    That’s why we offer a service called Find an Adviser.

    Wherever they are in the world, we will put TEBI readers in contact with an adviser in their area (or at least in their country) whom we know personally, who shares our evidence-based investment philosophy and who we feel is best able to help them. If we don’t know of anyone suitable we will say.

    We’re charging advisers a small fee for each successful referral, which will help to fund future content.

    Need help? Click here.

     

    © The Evidence-Based Investor MMXXII

     

     

The Evidence-Based Investor is produced by Regis Media, a specialist provider of content marketing for evidence-based advisers.

Contact Regis Media

Disclaimer: All content is for informational purposes only. We make no representations as to the accuracy, completeness, suitability or validity of any information on this site and will not be liable for any errors or omissions or any damages arising from its display or use. Full disclaimer.

© 2020 The Evidence-Based Investor. All rights reserved.