Reviewing Landmark Yale Study on Mutual Funds Management With Ed Rempel

In 2006, two professors at the Yale School of Management — Martijn Cremers and Antti Petajisto — published a paper (since updated in 2013 by Petajisto) that described a new method for measuring the active management of mutual funds that they termed “Active Share”.

The main point from the study following Ed Rempel’s review is that Active Share significantly predicts fund returns. The funds with the highest “Active Share” tend to outperform their benchmark indexes. All other actively-managed funds tend to underperform after expenses.

According to the original 2006 study, “Active Share is the fraction of a fund’s portfolio holdings that deviate from the benchmark index. The Active Share of a mutual fund ranges from zero (pure index fund) to 100% (no overlap with the benchmark). Active management has traditionally been measured with tracking error, which measures the volatility of portfolio return relative to a benchmark index.”

The paper revealed that nearly a third of the mutual fund industry in the United States was composed of “closet indexers.” In Canada, about 70% are closet indexers. These are funds that are said to be actively managed, but in fact passively invest most of their assets similar to the benchmark index. Truly active funds account for only about a quarter of the market.

Brampton, Ontario fee-for-service financial planner Ed Rempel reviewed the study and said that the most negative aspect of the rise of index investing is that closet indexers have proliferated even more than actual index funds. At the time of the study,closet indexers were about 30% of equity mutual funds, up from virtually zero in 1980 when virtually all fund managers were truly active.

Closet indexers obviously underperform, said Rempel.Their holdings are similar to the index, and yet they generally charge similar fees to truly active funds. They are probably the worst choice of equity investments, since you are not getting either a skilled fund manager or a low cost.

One of the main conclusions Ed Rempel draws from the Yale study is that nobody should own a closet index fund, adding that you should either have a truly skilled fund manager with a high Active Share or a low-cost index fund. But nobody should pay the full cost of a skilled fund manager for a closet indexer.

Despite this, closet indexers have become very popular for many reasons. Investment salespeople like them because they are easy to sell. Investors like to see big, solid companies they know in the top 10 holdings and are more comfortable during market declines if everyone else is down at the same time. Investors tend to think they are “safer”, but the study showed they are no less volatile or risky than truly active funds with totally different holdings.

He also shared some of the other insights from the study regarding fund managers that he considers valuable. These are placed in four categories.

The worst performers, according to Ed Rempel’s review, were low Active Share/low tracking error funds – closet indexers.

Low Active Share/high tracking error are “sector bets”. They have many of the index holdings, but take big bets in sectors, such as technology resources. They also underperformed with returns similar to closet indexers.

High Active Share/low tracking error diversified stock pickers tend to have many holdings, but they’re different than the index. They’re often skilled stock pickers whose funds move somewhat like the index just because they are quite diversified. They also tended to outperform.

Finally, high Active Share/high tracking error tend to be the best performers. They are concentrated stock pickers with fewer holdings. These are the bravest fund managers, said Rempel, because it takes courage to both hold larger positions and be very different from the index.

Ed Rempel’s review noted that the study defines “sector bets” as funds that try to outperform by being in the right sector, as opposed to picking the rights stocks. These funds tended to own companies in the index, but were heavily overweight in some sectors. They may be “sector rotators” or “market timers”. Think of it somewhat like actively switching between several sector funds or sector ETFs. They tend to lag the index, similar to closet indexers.

The study does a long way to prove its credibility, said Rempel. The initial study was U.S. funds, which he said is the hardest place to beat an index. But, he added that it’s probably the most comprehensive study that’s been undertaken on the topic because it includes daily stock and fund values for 24 years, compares every fund to 19 different indexes to find the closest one, identifies index funds and closet indexers, includes dividends and all closed funds.

Bottom line: having a high “Active Share” is one of the most important factors in identifying mutual funds likely to have an All Star Fund Manager that tend to outperform their index.