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Has a Way to Find the Best Performing Managers Been Found?

The Holy Grail for investors is the ability to identify in advance the active mutual funds that will outperform. To date, the overwhelming body of academic research has demonstrated that past performance not only doesn't guarantee future performance (as the required SEC disclaimer states), but it has virtually no value whatsoever as a predictor. (My upcoming book, The Quest for Alpha, provides a detailed summary of the evidence on the inability of individual investors, mutual funds, pension plans, venture capital and hedge funds to persistently generate alpha.)

However, Antti Petajisto claims he has found the Holy Grail, called Active Share. Active Share is the percentage of holdings that differ from the funds benchmark.

In his paper "Active Share and Mutual Fund Performance," he provided the following illustration. American Funds' Growth Fund of America (AGTHX) could be broken into two components:

  • The S&P 500 Index, which is the passive component
  • The deviations from the index, which is the active component
A stock that's overweighted (underweighted) relative to the index is an active long (short) position. For the Growth Fund of America at the end of 2009, 46 percent of the fund resembled the S&P 500, while the remaining 54 percent deviated and was considered the active portion of the fund, or its Active Share. Thus, investing $100 in the Growth Fund of America was equivalent to investing $100 in the S&P 500 together with $54 in the fund's active long positions and $54 in the fund's active short positions -- 54 percent being the Active Share of the fund.

The Results Keep in mind that an active manager can add value only by deviating from a benchmark -- either through stock selection (betting on individual stocks) or factor timing (tactical asset allocation involving betting on broad portfolio factors such as overweighting value stocks or shifting to cash equivalents). In his study, Petajisto used the time period 1990-2009 and controlled for the four factors of beta, size, value and momentum. He found that:

  • The average fund underperformed its benchmark by -0.41 percent.
  • Moderately active funds underperformed by -0.52 percent.
  • Factor bets generated underperformance of -1.28 percent.
  • Closet indexers (those with low active share) underperformed their indexes by -0.91 percent, slightly less than their fees.
  • Concentrated funds essentially just matched their benchmarks net of fees.
  • The only group that added value to investors was the active stock pickers: They beat their benchmarks by 1.26 percent, or 1.39 percent after controlling for the four-factor model.
Petajisto also confirmed prior research showing that fund size hurts performance. However, he noted that size hurts performance because it's correlated with the type of active management, not because it hurts performance within a type. He also found that expenses and fund age predict fund returns: Each dollar in expenses reduces returns by slightly more than a dollar, and a fund's return decreases by 15-17 basis points per year for every 10 years in existence.

Petajisto concluded that the "cross-sectional dispersion in stock returns positively predicts average benchmark-adjusted performance by stock pickers." He added: "Active share has greatest predictive power for returns among small-cap funds, but its predictive power within large-cap funds is also both economically and statistically significant."

Finally, Petajisto concluded that "There are some inefficiencies in the market that can be exploited by active stock selection. However, fund managers are not able to add value by betting on broader factor portfolios, indicating that they are more efficiently priced than individual stocks."

These findings are certainly surprising, and no doubt many active managers will be ready to say "I told you so." However, given the mountain of evidence against active management, papers like these always warrant a closer look. Tomorrow, we'll do just that.

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