Swedroe: No Big Edge For More-Active Funds

The prevailing wisdom is that the market for equities in emerging markets is less efficient than in developed markets. Unfortunately, the evidence doesn’t support this hypothesis. For instance, the S&P Indices Versus Active (SPIVA) scorecard showed that over the 10-year period ending June 2015, 92% of actively managed emerging market funds underperformed their benchmark, the S&P/IFCI Composite Index.

On an equal-weighted basis, the full universe of actively managed funds returned 7.2% over that period and underperformed the benchmark by 1.9 percentage points. On an asset-weighted basis, the underperformance was 1.2 percentage points.

More Proof Of Active Underperformance
As another example demonstrating that emerging markets are not inefficient, we can look at Morningstar data. Even with the significant survivorship bias in Morningstar’s data (a bias not found in the SPIVA data), for the 15-year period ended April 18, each of the three passively managed funds from Dimensional Fund Advisors (DFA)—which my firm uses to gain exposure to emerging market equities—outperformed the vast majority of actively managed funds. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)

The DFA Emerging Markets Portfolio II (DFETX) had a 25^th percentile ranking (which means it outperformed 75% of the surviving actively managed funds), and both DFA’s Emerging Markets Value Portfolio (DFEVX) and DFA’s Emerging Markets Small Cap Portfolio (DEMSX) had 1^st percentile rankings. That’s an average ranking in the 9^th percentile. And that’s even before considering the survivorship bias in the data, let alone the impact of taxes (the higher turnover of actively managed funds will typically create more negative tax consequences). It is hard to make the claim that emerging markets are inefficient in the face of those results.

The fact that a small percentage of active funds manage to outperform holds out the hope for outperformance. If there were just a way to identify ahead of time the few funds that will outperform in the future, active management in theory would be a winner’s game.

Unfortunately, the literature has shown how difficult a task this is to accomplish. Recently, several papers have claimed that, by using a measure known as “active share,” investors are able to identify the few winners.

I’ve previously discussed some of the issues researchers have raised in relation to the use of active share. Keeping those issues in mind, we do have a new study that attempts to determine if active share can be employed as a measure to identify the few future outperformers.

EM Active Share Up Close
Aron Gottesman and Matthew Morey, authors of the January 2016 study “Active Share and Emerging Market Equity Funds,” examined whether active share was predictive of future performance in emerging markets over the six-year period from 2009 through 2014. The study included 67 actively managed emerging market funds. Following is a summary of their findings:

• The most active quintile of funds had active share of at least 78.3%. The average active share was 83.2%, and the highest was 94.5%. For the middle quintile, the figures were 69.2%, 71.2% and 72.3%, respectively. For the lowest quintile, the figures were 61.3%, 49.1% and 23.6%, respectively.
• There’s a positive, and significant, relationship between the average level of a fund’s active share and fund performance. More active funds have significantly better performance than less active funds.
• A fund’s standard deviation of active share is a negative, and significant, predictor of fund performance. Highly active funds that change their active share over time have significantly worse performance than funds that keep their level of activeness consistent over time.
• Expenses are negatively and significantly related to fund performance.
• Active share and expenses are positively correlated. Funds with higher active share are more expensive.
• Because fees for actively managed emerging market funds are significantly higher than for passively managed ones, there is a high hurdle for active managers to overcome. Thus, closet indexing (funds with low active share) in emerging market equity funds robs investors of the opportunity to outperform. About 16% of the funds studied were closet indexers (had active share of 60% or less).

Gottesman and Morey reached the following conclusions: “We have found that the level of activeness matters for performance. More active funds outperform. In addition we have found that the consistency of the fund’s activeness matters also for performance. Funds that keep their active share consistent over time outperform funds who attempt to alter their active share over time.”

Returns Show A Different Story

Before you draw any conclusions, however, let’s review the authors’ findings on returns. They ranked funds by active share and placed them into quintiles. The table below shows the monthly returns of those quintiles over the period from 2009 through 2014.

While the two most active quintiles did have the highest returns, the least active quintile outperformed the middle quintile and second least active quintile. If active share were predictive, that shouldn’t be the case.

We can now compare the return of the most active quintile with the returns of the three aforementioned DFA emerging markets funds: DFETX, DFEVX and DEMSX.

First, note that all three DFA funds outperformed the bottom four quintiles of active share. Second, while the most active quintile of funds did outperform DFETX and DFEVX, by 5 and 3 basis points a month, respectively, they underperformed DEMSX by a much larger 33 basis points per month. Thus, it is possible that the most active quintile’s outperformance of DFETX and DFEVX was due to the funds in it having some exposure to small-cap stocks, not because they were good stock pickers.

At least based on these facts, it seems hard to make a compelling case that active share is a predictor of future outperformance. One thing we can say is that, unless you have funds in the highest active share quintile, your odds of outperforming are poor. That surely is a loser’s game.

We can add that, given the relatively narrow outperformance of the top quintile, it seems unlikely that taxable investors could benefit from using active share even if it were as a predictor of future performance.

Active Management Dooms Itself
There’s one other issue to consider regarding active share. If it is predictive, then active share contains the seeds of its own destruction. Here’s why: Jonathan Berk, in his paper “Five Myths of Active Portfolio Management,” suggested the following thought process: “Who gets money to manage? Well, since investors know who the skilled managers are, money will flow to the best manager first. Eventually, this manager will receive so much money that it will impact his ability to generate superior returns and his expected return will be driven down to the second best manager’s expected return. At that point investors will be indifferent to investing with either manager and so funds will flow to both managers until their expected returns are driven down to the third best manager. This process will continue until the expected return of investing with any manager is the benchmark expected return—the return investors can expect to receive by investing in a passive strategy of similar riskiness. At that point investors are indifferent between investing with active managers or just indexing and an equilibrium is achieved.”

Berk went on to point out that the manager with the most skill ends up with the most money. He then added: “When capital is supplied competitively by investors but ability is scarce only participants with the skill in short supply can earn economic rents. Investors who choose to invest with active managers cannot expect to receive positive excess returns on a risk-adjusted basis. If they did, there would be an excess supply of capital to those managers.”

There is another reason successful active management (and active share as a useful tool) sows the seeds of its own destruction. As a fund’s assets increase, either trading costs will rise or the fund will have to diversify across more securities to limit trading costs. In other words, its active share will fall.

However, the more a fund diversifies, the more it looks and performs like its benchmark index, becoming that dreaded closet index fund which, as we discussed, has almost no chance of outperforming. And we saw the results from closet index funds in the study by Gottesman and Morey.

Also keep in mind that the publication of papers on active share spreads the word, and thus speeds up the process that Berk described. For investors interested in how the publication of academic research impacts return predictability, I suggest a 2012 paper by R. David McLean and Jeffrey Pontiff, “Does Academic Research Destroy Stock Return Predictability?”

The bottom line is that active share doesn’t look to be that useful a metric, especially for taxable investors.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.