Fund investors pay for performance, and sometimes that performance is built on the managers' ability to stay ahead of their benchmarks, and the more activity usually means higher expense ratios. So when managers slow down, it's time to figure out why, writes Kathryn Spica of Morningstar FundInvestor.
When purchasing an actively managed mutual fund, investors want to make sure they’re getting their money’s worth.
Active managers on average charge higher expenses than passive products, such as index mutual funds or exchange-traded funds. Accordingly, their funds’ portfolios are expected to be distinct from their bogies, with a better chance of outperforming their benchmarks.
There are several metrics that can help investors evaluate how distinct their funds are, from returns-based statistics such as R-squared to those based on holdings such as active share. When these metrics show an active fund is becoming more correlated with its index, it can be a warning sign to investors that their fund may be losing its edge.
Parsing through the Morningstar 500, a few funds stood out with a decreasing active share, indicating a higher percentage of their portfolios now overlap with their respective index. While these funds may not be transforming into closet index-huggers, closer alignment with their indexes can be a tip-off for an investor that the active portion of one’s own portfolio is decreasing.
Large-blend fund Vanguard Growth & Income (VQNPX) is one example of a portfolio that is becoming more like its S&P 500 Index benchmark. In 2011, the portfolio’s active share was cut roughly in half, clocking in at around 30% as of March 2012 relative to the index, the lowest among active large-blend managers in the group. A subadvisor change was the reason.
In September 2011, Vanguard replaced subadvisor Mellon Capital with a trio of teams. Los Angeles Capital Management, D.E. Shaw Investment Management, and Vanguard’s quantitative equity team now each manage an equal-sized portion of the portfolio, using quantitative models to benchmark their risk levels against the S&P 500 Index.
After the management change, the number of holdings in the portfolio ballooned to over 750 stocks from roughly 150. On the plus side, the fund’s fees are so low that it only needs to make up about 15 basis points to pull even with Vanguard 500 (VFINX).
A similar shift occurred in the portfolio of USAA Aggressive Growth (USAUX) in July 2010, when USAA replaced manager Tom Marsico with subadvisors Wellington Capital and Winslow Capital Management. The fund previously held a fairly concentrated portfolio of roughly 50 stocks, but grew to around 130 stocks after the new subadvisors came on board.
The fund’s active share decreased by over 20 percentage points between the second quarter of 2010 and early 2011, confirming the additional holdings shifted the portfolio to more closely align with the fund’s Russell 1000 Growth Index benchmark. As of March, the fund’s roughly 56% active share was well below its average peer’s 74% active share.
Even if the firm running the fund stays the same, a change in lead manager can also shift a fund’s portfolio significantly, as seen at Neuberger Berman Large Cap Value (NPRTX). In December 2011, Eli Salzmann took the fund’s helm.
While the number of holdings remained mostly the same, at around 80 stocks, the fund became much more closely aligned with its Russell 1000 Value Index holdings. The active share dropped to 56% from roughly 78% between the third quarter of 2011 and first quarter of 2012, landing below its average peer’s 71% active share for the first time.
While these changes alone may not necessarily be a bad thing—volatility may decrease at the funds, for example, as a portfolio becomes more diversified— the changes indicate the funds may have less of an edge against their indexes going forward.
Keeping an eye on metrics such as R-squared and alpha will confirm what type of performance effect these changes will have over time, and should help investors decide if the funds still fill a needed active role in their own portfolios.
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