For Martijn Cremers, co-creator of the active share measure, the ideal actively managed mutual fund is led by a manager who is supported by three pillars: skill, conviction and opportunity.
"You need all three to be successful in the long term," says Cremers, whose recently published study can help advisors distinguish between actively managed mutual funds that are primarily closet index funds and those that are truly actively managed by skilled stockpickers.
(Related on ThinkAdvisor: Will Active Share Be the Robo-Advisor Killer?)
Active share is a measure of how distinct a portfolio is from its index benchmark, but it doesn't necessarily indicate whether a fund will outperform its benchmark. That ability depends on the three pillars.
Skill
Skill is the ability of a manager to identify good investment opportunities, not just investments that are outside of a benchmark, says Cremers, a professor of finance at the University of Notre Dame, who spoke with ThinkAdvisor recently.
(Related on ThinkAdvisor: Asset Managers Struggle With Outflows, Fee Compression)
Funds can have a large active share but still underperform if their managers lack investment skill. "Active share is not a measure of skill," says Cremers. "It's a measure of how distinct a portfolio is."
Conviction
Conviction is a manager's willingness to maintain positions for the long term — a minimum of roughly three years, according to Cremers. Patience is one measure of conviction, but "being patient in an impatient world is difficult to do," says Cremers, describing the current investment environment where managers are evaluated based on short-term performance, be it monthly, quarterly, semiannually or annually.
(Related on ThinkAdvisor: Is 2017 the Year of Active Management?)
The best performing managers will also exhibit the courage of their convictions, daring to be different, using strategies that are not easy to replicate, says Cremers. A manager may be right over three years, for example, but wrong for the next 6, 12 or 18 months. Will she have the courage to stick with the strategy?
Opportunity
Opportunity is the ability of managers to use their stock-picking skills without constraints that could limit their ability to maintain a high active share. Opportunity is especially important for large-cap equity funds because large-cap funds with low active share tend to underperform, but large-cap and small-cap funds with patient strategies (conviction) and high active share outperform on average, says Cremers.
Active Fees
Fees are another important variable for advisors to consider when choosing among actively managed funds, specifically those funds with low active share, says Cremers. Fees are not an important factor for high Active Share funds.
A fund's fees defines "the hurdle rate" that the manager has to top in order to outperform a benchmark index fund. The higher the fees, the higher the hurdle rate, says Cremers.
