Passive Overlap: Exploring Closet Indexers

October 20, 2009

Passive Overlap Exploring Closet Indexers In a working paper titled “How Active Is Your Fund Manager?” Martijn Cremers and Antti Petajisto introduce a metric they call “active share,” which is a measure of how different a fund’s underlying holdings are from the holdings of its benchmark index.1 They find that a significant number of mutual funds (especially large-cap funds) have significant active share. The purpose of this paper is to explore this concept and provide the reader with an idea of how “active” domestic equity funds really are.

In this paper, the author uses the term “passive overlap” to describe the percentage of the portfolio holdings that are the same as the respective index; it is essentially the opposite side of the coin of the “active share” concept outlined by Cremers and Petajisto. The calculation methodologies differ slightly: For comparison purposes, passive overlap would be roughly one minus active share.

Exploring Active Value

First, it’s important to point out there’s nothing necessarily wrong with a mutual fund that has holdings that are very similar to its benchmark (i.e., a high level of passive overlap), even if it is not an index fund. The goal of any actively managed fund should be to outperform an appropriately determined benchmark either on a pure return or risk-adjusted basis. If a portfolio manager feels that he or she has no unique insight into a particular sector, it would only make sense to “index” that portion of the portfolio. However, the larger the percentage of the portfolio that becomes passively managed, the less the portfolio manager is doing to earn his or her fee. If active management cost the same as passive management, this would be of little concern; however, as many of us know, active management typically costs a good/great deal more.

The cost of passive management varies by category (where domestic large-cap equity tends to be the less expensive and international investing tends to be more expensive); investor size (where larger investors tend to pay lower fees than smaller investors); and manager (where managers with better performance should be able to command higher fees). For simplicity purposes, let’s assume the average index (i.e., passive) fund costs 20 basis points (bps) and the average active fund costs 100 bps (the author is fully aware that there are funds for both groups that cost a good deal more and a good deal less; consider this to be a reasonable approximation). Therefore, the “active value” of the active management should be equal to or greater than the difference between the two values, or 80 bps. Basic math dictates that the higher the percentage of the fund that is passively managed, the lower the probability that the fund will end up outperforming its benchmark.

While investors are willing to tolerate tracking error to varying degrees, the “cost” of investing with an active manager should be, in theory, based on the portion of that portfolio that is actually being actively managed. This statement should not be expected to hold unilaterally; however, it does make intuitive sense. If an investor knew which portion of the portfolio a portfolio manager planned to invest passively (i.e., the same as the index), ideally the investor would invest those monies separately and passively, thereby paying a lower investment management cost, and only leave those monies with the active portfolio manager that will be “actively” invested (for which the portfolio manager commands a higher fee).

While this type of strategy would be incredibly difficult (if not impossible) for the vast majority of investors to implement in the real world, a basic tenet of the reasoning is simply that the more similar the portfolio allocation is to the benchmark allocation, the less investment (e.g., a mutual fund) should cost. This point is presented visually in Figure 1, where different combinations of Passive Overlap and investment cost (i.e., expense ratio) are considered from the perspective of an investor looking to get the highest “value” out of active management.

 

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