Active Share And The Risks Of Relying On The Skills Of Active Fund Managers

18th Nov '19 by Ben Hobson

15 comments 2346 reads

A few months after launching the Woodford Equity Income Fund in June 2014, Neil Woodford’s team published what’s known as its Active Share score. In doing so, they made a bold statement about the type of investor that Mr Woodford was...

Active Share is a way of measuring how ‘active’ a fund manager is (when it comes to using skill and expertise) in constructing a portfolio. At the time, Mr Woodford was seen as one of Britain’s best money managers. And he was certainly by no means the only one to highlight his fund’s Active Share in the name of ‘transparency’. With a high Active Share score, he was effectively able to say: “look at how different my fund is to its benchmark”. And it really was. This was the score:

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But the subsequent collapse of the Woodford Equity Income Fund shows why Active Share can be at best misleading, and at worst, utterly useless. In just over a decade since it was introduced, Active Share has gone from being an interesting comparison tool to a measurement hijacked by parts of the fund management industry and touted as proof of being special. In reality, it may well be nothing of the sort.

How Active Share sets fund managers apart

In active fund management, the standard test of success (or otherwise) of a fund is how it performs against a relevant benchmark index. Those managers that outperform their index get the glory (and big fund inflows), although their outperformance is statistically short-lived.

Meanwhile, those that underperform their index suffer the indignity that their investors could have done better by buying the index ‘tracker’ and saving the active management fees.

This issue of paying relatively high active management fees for poor performance is an extremely sensitive one for the fund management industry. There is just no getting away from the fact that reliable performance - let alone consistent outperformance - is very hard to find among professional money managers. So why would anyone pay the high fees, which themselves drag down returns?

To get an idea of the scale of the problem, just look at the performance of US managers last year. According to Morningstar, of all the 429 funds it rated as Bronze or better in 2018, 91 percent of them lost money in 2018. Only 38 made…

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Nick Ray

18th Nov '19

This is my attempt to explain the arguments pro/anti active investment using Roulette as a simple test case.

(Let's assume European roulette with 37 numbers 0-36 and payout of 36 for a win, and no special rules for red-black bets when 0 occurs.)

With those assumptions the "expected" (maths speak for "average") return to a 1 stake is 36/37 for an edge of -1/37 = -2.7%.

You can make a range of different bets (single number, red/black, 1-12, etc) but the expected return is always exactly the same. However the volatility (standard deviation) of the returns varies significantly.

The equivalent of the market index (passive) tracker is to bet 1/37 on every number. The return is then always 36/37 on every spin. The volatility is zero and your return is always a guaranteed -2.7%. (This is a very boring (crazy even!) way to play roulette but from a theoretical point of view it the "optimum" way.)

In the stock market, the market tracker buys stocks weighted according to their market cap. The volatility is not zero, but in theory it is as low as you can get. The remaining volatility is the systemic or undiversifiable risk.

Now if you use an "active" strategy to play roulette (in other words, you don't bet on every number every play) then your returns will differ from the expected value - sometimes you will be up and sometimes you will be down. But because this is a very controlled situation, we can easily see that over a long period of time, any strategy will have the same -2.7% expected return as the passive strategy.

So the lessons of roulette are:

you cannot change the expected return but you can change the volatility.
low or zero volatility is very boring and players avoid it

Is the same true for the stock market? Does an active strategy simply increase volatility but has no effect on expected returns over a passive strategy (except that you are charged management fees on top for the privilege?) The answer if the stock market is an "efficient market" is "yes": you cannot out-perform the passive strategy, but you get a more exciting (higher volatility) ride.

Since all attempts to take advantage of inefficient pricing always push the prices towards the efficiency, and all attempts to get a free ride by using passive investing push prices away from efficiency, it seems likely that the market sits right on the cusp.

It seems to be the case that many "players" (amateur and professional) on the stock market are indeed bored by low volatility solutions. They deliberately (if subconsciously) seek out volatility in the strategies they use.

(Well, that gets us to about 1970 in terms of theory. If you want to argue about behaviour, stochastic processes and super-martingales, multi-factor models, etc well that's the fifty years after that!)

GrahamF

I had thought that the argument about active share was simply that it is very bad idea to pay the fees of an active manager (may be 0.5 - 1% more than a tracker) if in reality they were not very far away from the index. So, don’t buy an actively managed fund with low active share, buy a tracker instead.

I hadn’t seen marketing material that suggests any correlation between high active share and superior performance but then again if you’re going to big up the stock picking prowess of the fund manager then it does seem relevant to mention the active share level as a justification or demonstration that she/he really is a stock picker and not a closet tracker.

It seems like the whole of the actively managed industry is getting cast as a hopeless bunch of Woodfords right now when surely the likes of Nick Train, Terry Smith and James Anderson don’t deserve such condemnation.

It’s only a matter of time until the phrase “you’re a right Woodford” enters common financial parlance!

pka

19th Nov '19

There is an excellent paper entitled "The Inefficient Markets Argument for Passive Investing", which can be downloaded from this web page:

http://www.indexinvestor.co.za/index_files/theories_24.htm

This paper argues that about two thirds of active managers will underperform the index each year, even if the stock market is not 'efficient''.

Mike888

Generally speaking, it seems to me that the Achilles heel of many retail and pro active investors, is that they become too entrenched in their methods, probably due to early successes, but fail to recognise shifting market sentiment towards what they are, or are not, invested in. Or maybe worse, they feel their methods are easily transferable to a universe they havn't inhabited before.

You see it all the time, more vocally in the retail space, where impassioned voices argue over the merits of an individual stock or approach and find it difficult to acknowledge an alternate argument.

Bottom line is that retail investors I believe can more readily beat the market than active managers, but it requires an ability not to believe your own hype, be able to see the wood for the trees, and if necessary spot and move with the prevailing forces that drive the market.

There is an excellent paper entitled "The Inefficient Markets Argument for Passive Investing"

That is a very thought-provoking little paper. The clarity of his argument is excellent.

jonesj

I've purchased Investment Trusts when I want overseas exposure (which is a high percentage of the portfolio) and when I couldn't find attractive UK stock opportunities, I picked small cap Investment Trusts.
The selection of the trusts was based on the long term track record relative to the sector. I adopted this method around 2007~9, so replaced some previous holdings then.

I also set up a Google spreadsheet, which compares the price of my selected trusts with benchmark index tracking etfs. For example, an Asian small cap trust would be benchmarked against an Asian small cap index etf. My spreadsheet compares the CAGR of the pair, from the purchase date for the first position.
Out of 16 trusts, every single one shows a higher CAGR than the benchmark ETF.

"Out of 16 trusts, every single one shows a higher CAGR than the benchmark ETF."

Was that due to good active stock selection or due to the long-term effect of any gearing by those investment trusts, or perhaps both? Many investment trusts have taken out long-term loans and have invested that borrowed money in their chosen stocks, in addition to the original money they received from their investors, so their effective gearing is often over 100%. This gearing tends to enhance returns over the long-term, because stock markets tend to go up in the long-term, but it also makes investment trusts more volatile than their benchmark indices and can amplify falls in their share prices during bear markets.

Hi Nick,

I think your roulette analogy to the stock market is a very interesting one. However, it has the drawback that the expected return of a punter betting on roulette is negative, whereas the expected return of investment in the stock market is positive over the long term.

For example, you wrote in your post:

'The equivalent of the market index (passive) tracker is to bet 1/37 on every number. The return is then always 36/37 on every spin. The volatility is zero and your return is always a guaranteed -2.7%. (This is a very boring (crazy even!) way to play roulette but from a theoretical point of view it the "optimum" way.)'

I don't agree that is the "optimum" way to play roulette, because it guarantees a loss. Any other way of playing roulette gives one a small chance of walking away with more money than one started with. Therefore it is, as you wrote, crazy to bet 1/37 of your pot on every number on the roulette wheel.

However, it is a perfectly rational strategy to invest in an ETF or fund that tracks a stock market index, because your expected long-term return from doing that is positive.

In a way it doesn't matter than the roulette expected return is negative since we are comparing whether we can beat the expected return - whatever value it has.

But you are right that it does blur the argument. When playing roulette for any finite amount of time it makes no sense to pursue a strategy with no prospect of a positive return. (If however you play roulette for an infinite amount of time you will always have a edge of -2.7% per play no matter what strategy you use. (Or, more mathematically, the edge approaches -2.7% as t tends to infinity.))

It is possible to construct a version of roulette where the return is +2.7% per play to avoid this issue, although it makes the explanation a bit more untidy. (Have 37 numbers but pay 38 instead of 36 for a win.)

The key point though is that if you reduce the volatility it becomes easier to see what kind of real long-term return you are getting. With high volatility you can focus on the "ups" and mentally ignore the "downs". And it is just as true with the stock market. If you are up 10% for two years in a row it is just the same as being up 40% one year and down -14% the next, but that +40% will give you a nice buzz!

Of course, the premise that about two thirds of active managers (on a market weighted basis) will underperform the index each year, even if the stock market is not 'efficient', does not mean that it is impossible for a particular active manager to outperform the index consistently over a number of years. Warren Buffett is an example of an active manager who has done that.

I agree pka,

Also, I'm not sure I follow the parallels between roullette and active management, I agree that in a game of chance volatility is a symptom of how narrow you spread your bets and over time the average will play out, but investing shouldn't be considered as a game of chance. I know this to be true because I've been at this for decades, lived through two "proper" bears and easily beat the market of both short and long timescales. The fruits are there to pick, the harvest can be good, but you need to pick the ones that are ripe.

I suspect the outperformance of the Investment Trusts selected is due to:
1 Superior stock picking, particularly in small caps
2 Reduction in the discount (worrying, since this can work both ways)
3 A minimal contribution from gearing

Incidentally, every time I read a study reviewing whether it's possible to select good fund managers based on past performance, the study is always looking at very short term periods, like 3 years or so.

I'm not sure I follow the parallels between roullette and active management

The important point is the concept of an "efficient market" and what it means for participants. Roulette is just a very simple efficient market so it easier to see some of the principles.

How would you illustrate the behaviour of an efficient market?

20th Nov '19

Quite simply Nick, I don't believe in the concept of an efficient market and never have done, else how does anyone beat the market. Evidence proves, at least in my mind and my experience, that the market is inefficient.

21st Nov '19

Hi Nick, You wrote:

"It is possible to construct a version of roulette where the return is +2.7% per play... (Have 37 numbers but pay 38 instead of 36 for a win.)"

With this interesting artificial version of roulette, I think the optimal strategy would be to bet 1/37 on every number, because by doing that one is guaranteed to always win a small amount at each spin of the wheel. Any other strategy has a non-zero, although low, probability of losing money over a finite number of spins.

For many people, the pain of losing is greater than the pleasure from winning, so a strategy that minimises the probability of losing by minimising volatility would be good for them.

Active Share and the risks of relying on the skills of active fund managers

How Active Share sets fund managers apart

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Ben Hobson

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