Active managers actually do outperform if...

November 23, 2015 09:00 AM

Why do most active equity mutual funds underperform? 

The common perception is that active funds lag for two reasons: Poor stock-picking skills and high management fees.

But not according to Thomas Howard, Emeritus Professor of Finance at the University of Denver and CEO/Research Director of AthenaInvest. He has explored this question extensively and has reached an interesting conclusion. 

Howard’s research rejects that core premise and states that 90% of active equity funds have superior stock-picking skills; meanwhile, the best performing funds are the most likely to justify higher fees.

Howard concludes in a soon-to-be reviewed academic paper that the primary culprits are portfolio management attributes that overshadow stock-picking prowess. This means that funds are managed by great active stock-pickers, but a series of business and management decisions at the portfolio level along with outside market factors create performance drag against benchmarks.

Howard identified three true drivers of underperformance. And his work has the potential to provide actionable insight to portfolio managers and traders seeking to produce alpha. Howard explains that his latest research is designed to help allocators and investors identify funds with the ability to outperform the market and reduce susceptibility to portfolio drag. 

Athena's Beginnings

Steeped in Modern Portfolio Theory (MPT) when he left University of Washington with a Ph.D. in finance, Howard says new evidence on market behavior contradicted his education. Though he taught MPT early on, he embraced behavioral finance and has written several books and countless studies on the topic. His syllabus would reflect that evolution during his 30 years in the classroom. 

But his personal work and research took a major turn about 10 years ago when a friend who ran a mutual fund asked a subtle question about closet indexing. 

“My friend asked, ‘Why do they want to keep putting me in a style box?’” Howard says, referring to the graphical representation of a mutual fund’s characteristics and strategy. His colleague had strong performance and a narrowly defined strategy. But clients and industry professionals kept seeking style box classification for his fund. 

From that question, Howard launched a research product that grew to become his firm, AthenaInvest, which has broadened his focus on the issue of “active vs. passive” and the performance of active managers.

“I didn’t expect much to happen with this area of research on style boxes, but this is a project that just keeps on giving and produces new ideas. The first major thing that we determined is the effect of a style box on performance. If you ask a manager to stay in a style box, he will underperform by as much as 300 basis points,” Howard says.

That discovery prompted a series of new questions to explore, including how the industry categorizes managers. 

With thousands of funds in existence, Athena built a patented strategy framework that identifies what a manager does, how he does it and what is important to him. This allows the firm to cluster managers with other managers that do similar things. Next, the firm continued to examine performance until it reached an important conclusion—one that is the subject of Howard’s latest research on why most equity mutual funds underperform and how investors can identify the ones that do outperform the markets. 

“We’ve identified that the vast majority of active managers are skilled stock-pickers, which is what you would expect from this industry,” he says. “I taught for 30 years, and my best and brightest tend to go into the mutual fund industry. It’s hard to imagine that people so smart couldn’t be that good at what they do, which is to pick stocks. That has been a conclusion from our research and a large other body of other research: that they are skilled. If they’re not good, they’ll be eliminated from the survival-of-the-fittest mentality of the industry.”

That conclusion is important for two reasons: First, it ensures that entire generations of mutual fund managers weren’t wasting years of time and training. It also justified the very basic reality that the human mind can beat the market, and violated a widely held belief and large body of literature based on studies of aggregate active equity fund performance that suggest that active managers lack stock-picking skill.

But, with so many funds underperforming their passive counterparts, who are the culprits? 
“It’s not the stock-picking skill that is missing. It’s not the high explicit fees. It’s the fact that these funds – after picking stocks—go through a series of management decisions that ultimately destroy their performance. It is due to a variety of non-performance-related business and regulatory pressures that lead to building underperforming portfolios,” he says.

Howard states in his soon-to-be released research that several recent studies show that truly active funds—not the ones that designate themselves as active but also are in the habit of taking high conviction positions—do outperform their closet-indexing counterparts. And portfolio drag—the negative effect on performance that is most commonly attributed to fees—has been accelerated by three other distinct factors.

“First is asset bloat,” Howard says. “Funds get too large and are unable to do what they are good at. Second is the process of closet-indexing. Everyone begins to track their benchmark very closely. That’s where the style grade comes in, and it’s a serious problem. Third: managers over-diversify for reasons both in and out of their control.” 

As a result, Howard’s team used these metrics to create a new way to quantify portfolio drag and provide a system to identify the best-performing funds, all while displacing the common belief that active managers lack skill. 

They call it the Portfolio Drag Index (PDI).

Managers Feeling Bloated

When it comes to a mutual fund’s performance, bigger is not always better. 

Howard argues that asset bloat is the most obvious factor affecting performance of active stock-pickers. Why funds get too large isn’t a mystery given the incentives provided by an industry that rewards managers by paying them a percentage of assets under management. The more money a fund attracts, the more money the manager receives from annual fees. 

Few incentives to remain small exist, but Howard’s research indicates that smaller is indeed better. 

“At some point, everyone starts small and they do well. In fact, we see that small funds outperform larger funds, both in the active equity mutual fund and hedge fund industries. But then, more people put more money in and they begin to attract other funds. At some point you have to make a decision. Will you stay a size where you can execute your strategy or are you going to boost your AUM?” 

Howard suggests that many managers would prefer to stay on their own in order to stay lean and successful. Again, it all comes down to incentives and a measurement of risk versus reward.

“The reward to grow larger is greater than the cost of a drop-off in performance,” he says. “Besides, there is a lag in drop-off in performance, so people don’t detect that until it’s too late.” 

“These are powerful incentives and these have driven the industry into this situation [where asset bloat is such a driver of portfolio drag],” he says.

Addressing the associated impact of asset bloat on portfolio drag starts with the primary issue of how compensation is structured. Too much bloat will lead to poor performance and offers no clear benefit to investors.

“Unfortunately the current compensation arrangement has been fabulously successful in creating value— destroying PDI Group 5 funds, which now make up nearly 50% of industry AUM,” Howard explains.

Style Drift is no Drag

The style box has become largely popular in recent years thanks to research provider Morningstar’s placement alongside its one-to-five-star rating system. These boxes offer a visual representation of nine, equal-sized boxes to characterize a fund’s investment objective. Although Morningstar’s Don Phillips has been credited with its invention, Howard says it can be traced back to Frank Russell and Bill Sharp in 1984. 

According to Howard, the initial equity concept was divided into four boxes: Small and large cap, and low PE and high PE. However, that small theoretical concept evolved into something few had envisioned.

“Within a year people began to discuss style boxes,” Howard says. “It took off across industries without anyone really thinking about it or analyzing it carefully. We call it a leaderless stampede.”

Once the industry widely accepted style boxes as a proper measuring stick, the rigidity of such classifications would remain and ultimately have a quantified impact on performance, as much as 300 basis points according to Howard’s initial research. In fact, the managers are unlikely to use them outside of a brief conversation.

“Here is where the style grid plays an insidious role,” he says. “Every broker dealer, every wirehouse and every platform categorizes a mutual fund based on the style grid (Small-cap A, Large Cap-Growth), and they want fund managers to stay in that box once they’ve been categorized. But if you talk to managers, they don’t describe themselves based on these grids. They tell you what they look at and what aspects are important to them.” 

However, the industry expectation is for the manager to invest according to the benchmark and remain within a designated style box. Doing so ensures they can obtain a fund rating. 

“Style boxes force managers to do something outside of their strategy,” Howard says. “But that’s the industry framework.”

Meanwhile, the ongoing expectation that managers remain within their style box makes it very difficult to aim for optimal returns. This opens up the potential for, and benefits, to style drift. 

“A fund cannot outperform its benchmark if it does not style drift,” Howard says. “Russ Wermer’s paper from University of Maryland found that those funds with the least amount of style drift—on average—didn’t outperform, while the ones with the greatest amount of style drift did outperform. The reason is that style has nothing to do with strategy. The strategy is the way or methodology or investment approach needed to determine which stocks a manager thinks are the best ideas. But you pursue that wherever that takes you in the equity universe. If our strategy tells us to buy stocks in one place, we go in that direction, without regard for PE or small cap or mid cap. Those turn out to be irrelevant to us, and it’s true of almost every manager. Bottom line, style and strategy have nothing to do with each other. What drives performance is strategy, not style.”

Howard concludes that superior long-term performance cannot be delivered to investors without short-term under- and over-performance.

“They need to quit requiring funds to benchmark track and then hope they will outperform. This is not possible.”

Fixing this problem likely wouldn’t be difficult, and it’s sorely needed because, according to his research, closet-indexing is the most destructive aspect of portfolio drag. Howard argues funds should eliminate R-square requirements and shift focus away from short-term performance metrics and tracking errors.  


Finally, the continuous obsession with diversification is fueling increased portfolio drag, particularly as funds asset bloat. Howard states that as a fund sees an increase in assets, its number of new stock prospects shrinks and transaction costs increase. This creates a challenge for managers to maintain the fund’s investment style.  

“The evidence in our research--and others have said this as well--there are only 10 to 20 best ideas out there for a manager. Strategies are unique. Pretty much every manager has a different way of selecting stocks. So we really want managers to focus on their best ideas, and not on their bad ideas,” he said.

Apparently, some have taken issue with the fact that pushing beyond a specific metric that has proven to create drag has raised eyebrows from members of the financial community. 

“I’m absolutely stunned when I say that this is controversial,” Howard says. “Don’t we just want the best ideas from managers? Isn’t it what we want? Why are we hiring someone if it’s not for their best ideas? Again, the evidence says that once you get past 20 investments, it’s highly likely that the next investment isn’t going to do well. As the paper explains, any additional weighting on stocks ranked worse than 20 hurts performance.” 

The less-is-more approach also opens an important discussion about the differences between concentration and conviction and the associated benefits of each philosophy. Many investors—and managers—don’t steep themselves in understanding the effect on performance.

“There’s a difference between highly concentrated portfolios and high-conviction ones,” Howard says. “High conviction means you overweight your best ideas on a relative basis. When you do that, these results come rather clearly. In more than half a dozen research papers, the best ideas show that if you do it on a relative weight basis that high conviction positions outperform. Concentration isn’t the most important thing. It is the high-conviction and a low R-squared (correlation). It’s possible to have a concentrated portfolio that tracks the index. Concentration and the number of stocks are not a particularly good measure of performance.”

Finally, lag tied to diversification can find its roots in specific diversification requirements urged and mandated by regulators—specifically in tax treatment provided to a “a regulated investment company.”

Under the 40 Act, any mutual fund has a decision whether to register as an “non-diversified” or “diversified” investment company (the vast majority choose the latter designation). This standard requires that with at least 75% of the portfolio, the fund cannot invest more than 5% in the securities of any single issuer (e.g., Apple). 

In addition, no single investment can comprise more than 10% of any issuer’s total outstanding voting stock. Most funds diversify more than the regulatory standards require. That means, most of the funds extend beyond the 10 to 20 good ideas that fit an individual strategy.

“It just drives you crazy,” Howard says. “That’s a regulatory requirement. Why they do that is just beyond me. There’s no reason why a 40 Act fund, an investment fund, should have that sort of restriction that mandates over-diversification. Regulators require a number of things that make it very difficult to create a fund able to sustain superior performance. It’s frustrating.”

Make it attractive for funds to focus on their best ideas and avoid investing in low conviction stocks. 
A small number of stocks is all that are needed for proper diversification and investing in stocks beyond that number hurts performance.

The best funds right now

Howard’s team argues that because portfolio drag is such a critical factor in performance, a metric should help investors define which funds are susceptible. 

The team introduced the Portfolio Drag Index (PDI), which he says is predictive of subsequent fund alpha and future fund flows. As the PDI increases, both alpha and flows decline quickly. 

Thus an effective way to identify funds with the best chance of subsequently outperforming—and also generating positive flows—is to focus on those with the lowest PDI, more specifically, those with a PDI of less than 40.

What qualities do the sub-40 PDI funds have in common?

“You want small funds pursuing a narrowly defined strategy consistently in taking high-conviction positions,” Howard says.

This seems simple, but Howard notes that it may not be the most popular among investors, as certain emotional barriers may end up affecting the judgement of both investors and fund managers.

“Investors look at this and say, I want big well-known funds,” he says. “You get the same thing with equity investors who want to own Apple and Google [despite strong performance in small cap stocks]. This is very common across all classes. It’s unbelievable. During a recent hedge fund conference, a presenter explained that the small funds ($200 million to $400 million) outperform the larger funds. But the next thing she said was that all of the new, smaller funds are investing into the large funds. People just can’t help themselves. Building superior portfolios is straight-forward, but emotionally challenging. We think of our emotions as a giant barrier. Superior performance is there. If you can master your emotions, these opportunities exist,” he says.

In fact, the opportunities emerged through his research. As Howard noted, the top funds do not asset bloat, don’t closet-index, and don’t over diversify. When it comes to their PDI measurement, some dramatically outperform. Following this discussion, Howard outlined the top 10 funds that maintained a PDI of 20 or less over his firm’s sample period. “No bloat” (below) list these funds in alphabetical order. 

As Howard notes, these funds all had a low PDI for at least 24 months during AthenaInvest’s sample period, and the associated alpha figures provide a metric of subsequent performance.

For all 80 funds meeting these criteria during our sample period, fees averaged 1.43%; drag averaged 0.69% and alpha averaged 2.04%, while 63% of the funds outperformed. 

Moving forward, AthenaInvest’s goal is to establish a platform with the goal of making the data available to everyone. If someone wants to calculate the PDI of a particular fund, they will be able to visit the firm’s site. 

“That is our goal,” Howard says. “It’s just a matter of making it available.”

Howard is currently awaiting additional review of his team’s research and plans to release his paper and associated findings to investors.

About the Author

Garrett Baldwin is the Managing Editor of the Alpha Pages and the Features Editor of Modern Trader. An author and Baltimore native, he earned a BS in journalism from the Medill School at Northwestern University, an MA in Economic Policy (Security Studies) from The Johns Hopkins University, an MS in Agricultural Economics from Purdue University.