Last updated: 13:26 / Thursday, 2 July 2015
"Active Share" Flaws

Metric Used to Expose Europe's "Closet Trackers" Open to Criticism

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Metric Used to Expose Europe's "Closet Trackers" Open to Criticism
  • In response to heightening regulatory scrutiny more managers are voluntarily disclosing data showing the extent to which a fund's portfolio diverges from its benchmark
  • "Active share, however, is no panacea and used in isolation is more likely to be misleading", says Barbara Wall, Europe research director at Cerulli Associates
  • Cerulli warns that a manager who feels obliged to maintain a certain active share is at risk of picking the wrong stocks simply to increase the deviation from the benchmark

As the crackdown on "closet trackers" gathers pace in Europe, concerns are growing that the metric used to identify those funds that charge active management fees while merely hugging the index could undermine performance, according to the latest issue of The Cerulli Edge - Global Edition.

The regulatory spotlight has fallen on closet trackers recently. In May the Swedish government launched an investigation in the wake of the Swedish Shareholders' Association filing a lawsuit against a leading fund house, alleging that it had mis-sold closet trackers to retail investors. Regulators in Denmark and Norway have also been proactive.

Cerulli Associates, a global analytics firm, notes that in response to heightening regulatory scrutiny more managers are voluntarily disclosing data showing the extent to which a fund's portfolio diverges from its benchmark. "Active share" is the most commonly used measure, with a score less than 60% deemed to be index hugging.

"Active share, however, is no panacea and used in isolation is more likely to be misleading. It should be used alongside other relevant metrics, such as information ratio data showing the portfolio returns above the benchmark in relation to the volatility of those returns," says Barbara Wall, Europe research director at Cerulli Associates.

Noting that there are times in an investment cycle when it might be prudent to stay close to the benchmark, Cerulli warns that a manager who feels obliged to maintain a certain active share is at risk of picking the wrong stocks simply to increase the deviation from the benchmark. Strict adherence to the tool may also prevent a manager from buying stocks that have a large weight in the index, even if they are expected to outperform.

Another limitation concerns the definition of being "active", which typically refers to the actual shares that are owned. But "active" can also apply to a portfolio that largely adheres to the index, provided the manager has not simply taken a buy-and-hold approach and that performance is influenced by the timing of trades in those constituents.

Firms that are already disclosing the active share figure tend to have house management styles that are unconstrained in relation to benchmarks. Firms where the emphasis is on delivering outperformance with a relatively low-risk, low-active share element would be understandably anxious, says Cerulli, about publishing their active share figure. "They would also point out--with some justification--that a low active share doesn't mean they are a closet tracker and that they should be judged on performance alone," says Wall.

Cerulli believes that, used in conjunction with other metrics, active share can be a useful tool in promoting accountability and transparency. Laura D'Ippolito, a senior analyst at Cerulli, says: "Views within the European fund industry on the value of the active share figure differ widely, but what is clear is that the debate--which also takes in the active/passive issue--is only going to intensify."

Other Findings:

  • With active exchange-traded funds (ETFs) at long last gaining traction in the United States, active mutual fund managers should seriously consider offering their strategies in these securities, advises Cerulli. It notes, however, that the path to success remains difficult. Another structure the firm recommends is the new exchange-traded managed fund.
  • The penetration rate of mutual funds in Asia ex-Japan has dropped to about 6.5% of household financial assets (HHFA) in 2013 from 9% in 2009, despite HHFAs expanding at, or close to, double-digit rates annually. Cerulli believes that the decline can in part be attributed to the short-termism that drives investment--in Taiwan, for instance, Cerulli has found that fund retention ranges from about six to nine months for the average investor, while in China it can be as short as a month. The firm says that analysis of the decision-making provides useful insights for determining product selection.
  • In the United Kingdom, active management is no longer the be-all and end-all for discretionary investment managers, says Cerulli, noting that a combination of regulatory change and the low-growth environment is forcing firms to review costs and portfolios. Not only are passive funds now more common in discretionary portfolios, but their role--and that of active funds--is changing. The analytics firm says that active managers face a challenge in staying relevant in a world in which cost is king, passives are core, and sustainable alpha is key.
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