Author: Jemima Joseph is an associate analyst with Morningtar. This article appears in part from a Morningstar investment newsletter with commentary from Harvest.

Investors always want the most bang for their buck and this does not differ when it comes to funds management. In the active managed funds industry, it is difficult for investors to evaluate whether their so-called actively-managed fund is cost-effective and beneficial to their broader investment experience.

The issue of just how “active” actively-managed funds are and whether higher fees attached to such offerings are warranted has been an issue of great contention within the funds management industry.

 

Harvest: This is an interesting take on the issue of active management. It provides some “science” around the level of conviction a fund manager has in terms of their stock selection. That is, how far is the fund manager mirroring or alternatively moving away from the benchmark ?

 

Firstly what is active management?
Active management is all about beating a benchmark index such as the S&P/ASX 200. Managers will adopt various strategies, either in order to determine which stocks they feel are under or over-valued and buy or sell accordingly.

One way investors can assess the “activeness” of a managed fund is to look at its active share score.

Active share scores
An active share is a calculation that measures the proportion of a managed fund’s portfolio holdings against its relevant benchmark. An active share score is measured as a score out of 100. The higher the score, the more active the approach has been. For example, an active score of 80 indicates that 80 per cent of the portfolio differs from the benchmark, while the remaining 20 per cent mirrors the index.

It is important to note that this not a perfect measure as it merely indicates the activeness of a fund at a particular point in time, which may not be a true representation of the fund’s strategic positioning.

However, Morningstar does highlight that despite this drawback, active share scores do provide investors with a meaningful insight into which fund managers are more active in their differentiation against the index and which have portfolios sticking more closely to benchmark positions.

 

Active return generators or closet indexers?
Morningstar’s report showed a wide dispersion in activeness during 2010. Table 1 shows the three most active large-cap Australian share funds.

Table 1: Large-Cap Australian Share Strategies – Highest Active Share Scores

[fusion_old_table id=1/]Source: Morningstar Direct

At the other end of the spectrum, Table 2 shows the Australian large-cap share strategies with the lowest active share scores.

Table 2: Large-Cap Australian Share Strategies – Lowest Active Share Scores

 [fusion_old_table id=2/] Source: Morningstar Direct

In short, these funds have the closest resemblance to the index.

 

Harvest: This then begs the question as to whether these funds are truly being actively managed (or are simply “closet indexers” as the author questions). And then the value question is, is the investment management fee being charged appropriate when the outcomes are likely to differ little to that achieved with a traditional passive indexed approach. Is the investor then really getting good value ?

 

Do higher active share scores result in better returns?
Most investors seek out actively managed funds with the hope of obtaining that extra bit of active return promised by active managers. But just because a fund has a high active share score, do these funds perform better?

A good way to determine this is to compare the returns experience of two high “active share” score funds – Lazard Select Australian Equity Fund (6837) and Dimensional Australian Value Trust. Both funds had an active share score in excess of 65 per cent, however, their returns differed considerably.

Dimensional achieved an impressive one-year and three-year trailing total return of 9.58 per cent and 4.12 per cent compared to Lazard’s woeful 5.22 per cent and -3.16 per cent (as at February 2011). From this is it evident that just because a fund has a high active share score this will not necessarily translate into a high return for the investor.

Are you paying active fees for passive management?
As mentioned previously, actively managed funds tend to attract high annual fees. However, in light of the above findings, is this always justifiable? Consider Colonial First State Acadian Wholesale Australia Equity (13522), with a high 1.22 per cent annual fee, an active share score of only 43 per cent and one-year and three-year trailing total returns of 8.37 per cent and -3.26 per cent (as at February 2011). Morningstar says if this persists, investors should start to question the value they are getting for their money.

What does this mean for investors?
Despite its limitation, active share scores do provide investors with a useful insight into understanding the activeness of their fund. Morningstar’s Valtwies believes investors should look for offerings with a reasonably high active share score, a consistent performance throughout the cycle, tax efficiency achieved through low turnover, and above all, low annual fees.

It is evident that investors must tread carefully when navigating through the active managed funds space and this discussion highlights the important of knowing exactly what you are getting into before investing.

 

Harvest: This article seems well researched and presses home an important point in terms of fund managers and their investment management fees. Our view is that while fees are a consideration, it is what you are getting for those fees that is the critical part of the argument. Remember the old adage: “Fees are what you pay. Value is what you get”.

It is unlikely you are going to get much outperformance if a manager solely or largely “hugs” an index. So Harvest’s message is to be sure you’re not paying active fees in return for index performance.