How “Active” is Your Manager?

Historically, passive investing was really only available to large institutional investors. These investors had sufficient scale to invest in all the securities in an index like the TSX Composite or the S&P 500, and continually re-balance these holdings to mirror the returns of the Index itself as closely as possible. The advent of exchange traded funds (“ETFs”) brought the opportunity to invest passively to the retail investor. For relatively little cost investors can “buy the index” today through ETFs. The popularity of ETFs has grown rapidly and the offerings have proliferated.

Nexus believes strongly in the value of active management for a variety of reasons. While active management is typically more expensive than an ETF¹, good active management can provide many significant benefits (and, hence, “value”) to investors. However, the purpose of this note is not to weigh the pros and cons of active and passive management. Instead, we would like to highlight a “dirty little secret” of active management that is not well known. Some call it closet indexing.

Closet indexing refers to the practice by a so-called active manager of constructing a portfolio not substantially different from the index. This portfolio may perform well or it may perform poorly – but it won’t perform much differently than the index. What an investor should know at the time of purchase is that he or she is paying an active management price and really only getting passive management investments. This is not good value no matter what the outcome.

According to a recent article in The Globe and Mail², Canada’s mutual fund industry recently was identified by a team of researchers as the world leader in closet indexing. Fully 37% of assets in Canadian equity mutual funds fall into this category. But how on earth is the average investor ever supposed to evaluate whether a manager is a closet indexer before deciding to invest?

Thankfully, there is a metric known as “active share” that can illuminate this issue. Those who attended Nexus’s annual client presentation in November may remember our discussion of active share. A portfolio that is identical to the index has an active share of zero. For example, an ETF or an index fund that mirrors the TSX Composite has an active share of zero. A portfolio that has nothing in common with the index has an active share of 100. A portfolio can gain active share by owning shares not in the index, by not owning shares that are in the index, or by simply owning shares in the index in different weightings. In the judgment of the finance professors who led the study referred to earlier, a portfolio with an active share greater than 60 is deemed truly active.

At the end of 2015, Nexus’s active share was 74 when compared to our blended equity benchmark. By comparison with many of the mutual funds examined in the survey, this is a high number. It is also high when one considers how concentrated the Canadian market is with many blue chip stocks. It is not easy to be “different”.

To have an active share higher than Nexus’s, one would need to eschew many of the country’s leading businesses; for example, the banks, the pipeline companies, and the telcos. In some cases, this might be sensible, but to avoid them all would be highly unusual. Many of the mutual fund companies with shockingly low active share metrics (like in the 20s or 30s) hide behind the excuse of our market’s concentration, although they don’t go on to explain why investors should pay 2% or 3% per year in fees for a product that is little different than an ETF. In these funds, it is not likely investors are getting good value for their fees.

At the end of the day, the only thing that really matters is whether your portfolio performs sufficiently well to justify the fee you have paid. However, this can only be determined in hindsight. The investing decisions we make are prospective. To give yourself a chance at success you need to look carefully at the fee being charged relative the approach your manager is taking. We at Nexus strongly endorse active management. But investors need to make sure they are getting value for money. Active share is a valuable tool to help guide the decision making process.