Active Fees, Passive Results

Posted on July 16th, 2015 by Ben Connard

We benchmark most accounts to a combination of the S&P 500 and the MSCI All Cap World Index (ex US). Our goal is to provide better risk-adjusted returns than the index through disciplined investment in strong companies trading at discounts to their intrinsic values. The first step to outperformance is creating an account that is actually different from the index. This is intuitively obvious, but some studies have shown that funds are increasingly going in the opposite direction.

The blended benchmark consists of about 2,000 names. We essentially pick the best 30 to 35 names in the benchmark plus a few other names that aren’t in the benchmark. We can quantify the difference between a portfolio we manage and the benchmark by calculating the “Active Share” of the account, which is the sum of the difference in security weights. An active share of 0% means the account matches the benchmark exactly (no difference in weightings) and 100% means it’s entirely different. Our active share falls in the 90% range as we are active stock managers whose goal is to outperform the benchmark.

In the early 1980’s, most assets were in funds with a highly active share of 80% to 100%. Over the last 30 years, the percent of assets in these funds has fallen to about 20%. A large chunk of the money has gone to pure index funds. The more noteworthy development is that about 1/3 of assets are going to “Closet Index” funds. These funds charge the higher fees associated with active management, but don’t have enough active share to actually outperform the benchmark. In other words, the results are more in line with passive funds and thus they don’t represent a good investment.