Interest in passive investing has increased considerably in recent years, but it doesn’t mean active management no longer has a place in investor portfolios. Despite claims to the contrary, evidence shows that not only are active strategies still viable, they are indispensable for capturing superior long-term, risk-adjusted returns.

Critics of active strategies typically cite reports that claim most active managers fail to beat their benchmarks. The problem with such reports is they do not factor in that a significant number of mutual fund managers who are billed as active actually deviate very little from their benchmarks. “The reason why the average mutual fund underperforms is because of those closet indexers,” says Daniel Nicholas, client portfolio manager at Harris Associates L.P. in Chicago. Recent research suggests that almost 40% of Canadian equity funds are index-huggers.

Truly active funds can and do outperform. The key is to understand how to determine whether a fund is truly active, and how to identify which active funds are likely to outperform.

Active Share: The critical first step

A truly active fund will have a high Active Share. This metric expresses, in percentage terms, the portion of a fund that differs from its benchmark. For example, a fund with an Active Share of 83% is 83% different from its benchmark, which creates strong potential to generate alpha.

Funds with an Active Share below 60% are generally considered closet indexers.

The formula for calculating Active Share is highly complex. If the metric is not provided by the fund company, advisors can compare a fund’s holdings to its benchmark. This will not be as precise as the metric yielded by the formula, but for practical purposes it’s acceptably accurate.

Picking winners: Active Share and Fund Duration

High Active Share, by itself, is not an indication that a fund will outperform, notes Nicholas. Recent research has shown the key to active fund outperformance is a combination of:

  • High Active Share
  • High Fund Duration

Fund Duration describes how patient a mutual fund manager is with the fund’s holdings. This metric is critical, notes Nicholas, because it can take as long as three to five years to capture the full alpha opportunity presented by undervalued stocks. Fund managers with high Fund Duration have the patience to let these opportunities reach their full potential, while those with lower Fund Duration tend to sell winners too early.

The benefit of combining high Active Share with high Fund Duration is clear from the chart below, which is based on a large sample of all-equity U.S. retail mutual funds and institutional portfolios.

As with Active Share, calculating Fund Duration is highly complex. But there are alternatives, explains Nicholas. “Two proxies that are more readily available on databases and from the managers themselves are holdings-based fund turnover and the self-declared fund turnover ratio.”

Look for an Active Share of about 90% and a turnover rate under 50%. Nicholas says that owning multiple high Active Share funds with overlapping holdings is counterproductive because “it will actually lower the average Active Share across a portfolio.” Accordingly, advisors should carefully examine fund holdings to minimize redundancies.

Get granular

Drawing on the work of author Michael Mauboussin,1 Nicholas suggests three additional criteria to narrow your shortlist of high Active Share, high Fund Duration managers.

A fund manager should have a strong (1) analytical process, (2) behavioural process, and (3) organizational process.

Portfolio managers with strong analytical processes tend to buy businesses at high margins of safety, build focused portfolios from high-conviction ideas or even take a private equity approach to valuing businesses.

Strong behavioural processes help overcome psychological biases and give fund managers the confidence to go against consensus.

Sound organizational processes promote an alignment of fund managers’ interests with those of investors.

Active and passive can coexist

While passive strategies can certainly have a place in client portfolios, investors of all types and risk tolerances can also benefit from carefully selected active mandates.

To learn more about the innovative Natixis approach to portfolio construction, which includes consideration of Active Share and Fund Duration, visit durableportfolios.com.

1Mauboussin, Michael. “The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing.” Harvard Business Review Press, 2012, p. 168.

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