Active management is a sum zero game before cost, and the winners have to win at the expense of losers — Nobel laureate Eugene Fama
Active management, which involves paying mutual fund managers hefty fees for their stock picking skills, has been targeted by several investing luminaries, from Warren Buffett to John Bogle. On the other hand, passive management, or investing in index funds which track an index and charge low fees, has been in favour in the developed markets over the past decade.
Almost 30 per cent of the equity assets in the United States are now managed passively. In India, this figure is more modest at a mere 3.8 per cent. Bogleheads, as fans of John Bogle the legendary founder of the first Index Fund (Vanguard) like to be called, contend that active management is a sham and merely a ploy by savvy marketers to extract exorbitant fees from unsuspecting investors in return for suspect stock picking skills of fund managers.
Fans of the active approach counter by saying that active management requires acquisition of information and analysis of stocks and the fees are justified given the high cost of acquiring such information. While there are merits in both the arguments, the greater peril for an Indian investor lies in the fact that the line between active and passive management is often blurred in India. Thus, the first challenge for an Indian investor is to identify the management style of the fund notwithstanding her investing preference (active or passive).
The worst of both worlds
All that glitters is not gold. While the majority of the mutual funds in India identify themselves as active managers, in reality most of them are not.
A large number of Indian mutual funds are “benchmark huggers” or “closet indexers”. These funds promise active management of investor capital and charge fees accordingly (higher than 1.5 per cent of AUM) but then merrily proceed to invest most of their AUM in stocks that comprise their benchmark, thereby largely mimicking the performance of the benchmark index.
This means that investors end up paying a much higher fee (almost 100 bps higher) for a performance that could have been achieved by investing in a low-fee index fund.
Therefore, on a net basis, the investor loses money to the fund manager who claims to be an active manager but is essentially running an index fund. With these closet indexers, investors end up suffering from the worst of both worlds with high fees and benchmark performance.
However, investors need not despair. With information available for free on websites such as Morningstar and Value Research, they can easily avoid the deadly embrace of these “benchmark huggers”.
While there are several statistical metrics that can be employed jointly to identify “closet indexers”, the first and easiest way to take a stab at the problem is by analysing the portfolio holdings of the fund and comparing them with the benchmark.
If the largest holdings in the fund have weights that are similar to the weights of those stocks in the benchmark index, it is likely that the fund is a closet indexer. While this test is not comprehensive, it works well as a “back of the envelope” measure of closet indexing.
When more is less
Active management is based on the principle of superior information or analysis. What this means is that the fund manager is able to use his superior information/analysis to generate greater returns for the investor. However, such information cannot be acquired by a single fund manager for several firms.
Therefore, truly active fund managers with superior information or analysis will hold only a few select stocks for which they have some information advantage (think Warren Buffett). In contrast, we often see Indian mutual funds hold up to 100 stocks. This is a classic sign of closet indexing.
A large stock holding implies that the fund manager is not confident of his stock picking skills and is trying to hedge his downside by trying to mimic the benchmark index.
Statistics to the rescue
Notwithstanding the common jibe about “lies, damned lies and statistics”, when it comes to identifying closet indexers siphoning off investor fees, statistics is a powerful instrument of truth. Several statistical measures, all of which are easily available, when used in conjunction with each other can clearly expose closet indexers.
Primary among these measures is the tracking error. It measures the difference between the performance of the fund and its benchmark for a given time period.
Truly active funds have high tracking error because of the fact that they are run by talented managers trying to outperform the benchmark index. Closet indexers, on the other hand, have low tracking error because they are run by fund managers trying to mimic the performance of the benchmark while charging high fees.
Another powerful measure of closet indexing is R squared. It measures the degree to which the fund and the index move together. A high R squared is a sign of a closet indexer, while a truly active manager has a low R squared.
Several Indian fund managers have taken to heart Lord Keynes’ contention that in the world of finance, it is often better to fail conventionally than succeed unconventionally. These managers hug the benchmark to protect their reputations while charging high fees in return for promises of active management.
Investors should carefully examine the performance of fund managers and check for signs of closet indexing to avoid ending up with the worst of both active and passive worlds.
The writer is director at Arrjavv