Investors know what they are paying in fees, but more should be asking if they are getting what they pay for.
A version of this article was published in the March 2017 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.
Fund fees command a lot of attention, and rightfully so. They are, after all, the most reliable estimator of a fund’s return prospects. As Vanguard founder Jack Bogle has said time and again, “In investing, you get what you don’t pay for.” But that doesn’t mean investors should select funds based solely on fees. There are numerous factors that should be taken into account when choosing funds. These include the skills, experience, and structure of the fund’s management team, the process they employ (which is largely dictated by an index methodology in the case of most index funds and exchange-traded funds), and whether the fund’s sponsor is a sound steward of shareholders’ capital, amongst others. It can also be useful to take a more holistic approach to assessing fees. Here, I will explore a different approach to framing fund fees, one that looks not just at how much you’re paying, but also what you’re getting.
A Brief Detour Through Active Share
Active share was first introduced in a 2009 research paper that claimed the measure could be used to predict fund performance. Specifically, the authors found that funds with higher active share outperformed those with lower active share. Roughly speaking, active share is a measure of the amount of active management in a portfolio. The less a fund looks like its index (by way of holding nonindex stocks, omitting index stocks, or having over- or underweightings relative to the index), the higher its active share. An index fund that perfectly replicates its bogy would have an active share of zero. A fund that owns half the stocks in its benchmark in their corresponding weightings would have an active share of 50%. A fund that looks nothing (and I mean nothing) like its benchmark would have an active share of 100%. Funds with low active share are often labeled “index-huggers” or “closet indexers.” Funds with high active share are deemed more desirable.
Asset managers, consultants, and fund selectors immediately latched onto active share. A new predictor of fund performance that isn’t fees? Yes, please! The measure was quickly introduced into the popular lexicon, and there was no looking back. But then...
A number of researchers subsequently threw cold water on the concept. As it turns out, the funds with the highest active shares tended to be small-cap funds. Small-cap managers benchmarked to the Russell 2000 Index (lots of stocks, smaller weightings), are far more likely to have a greater active share than large-cap managers measured against the S&P 500 (fewer stocks, larger weightings). In essence, the real finding of the original active share paper was that small-cap funds had better odds of beating their benchmark than large-cap funds. This is hardly groundbreaking news.
Is active share meaningless? In my opinion, the answer is a resounding no. But its value to investors is descriptive rather than prescriptive. It does exactly what it sets out to accomplish: It measures the magnitude of active management present in a portfolio. It's a useful complement to other measures of the degree of active management, such as tracking error. But these measures are not predictive. Remember, there is a certain degree of symmetry to the outcomes of taking active risk. For every high-active-share manager in a given universe that beats “the market,” there is another high-active-share manager on the other side of the distribution licking their wounds.
Back to Fees
Active share can also be helpful in scaling fees. No one wants to pay active-management fees to an index-hugger. Using active share to reframe fees can help investors understand how much bang (active share) they are getting for their buck. In a 2015 study, Martjin Cremers and Curtis Quinn expanded on the active share concept, introducing a measure they refer to as active fee, which is measured as follows:
Active Fee = [ER - (1 - AS)*PF] / AS