Investment research house Morningstar has published a report examining the “active share” data of European equity funds purporting to be actively managed. The findings show that 20% of such funds qualify as “closet indexers”, leaving investors with active-management-type fees despite the fund behaving like a passive index tracker.
One-fifth of European “active” equity funds are closet trackers, according to an evaluation of active share data from Morningstar.
The report appears to be yet another example supporting the case for embracing low-cost index funds such as exchange-traded funds, which have been shown to consistently outperform their active counterparts on a net-of-fees basis.
According to the S&P Indices versus Active (SPIVA) US scorecard report last year, over the longer term (five- and 10-year investment horizons), 80.8% and 79.59% of large-cap managers, respectively, failed to deliver incremental returns over the benchmark.
Active share measures how much a fund’s holdings deviate from its benchmark index. Funds with an active share score of 100% would have no common holdings with the index, while funds with an active share of 0% would be identical in holdings and weights to its benchmark. The higher the score, the more actively the fund is managed.
According to Morningstar, average active share for European large-cap funds was 70% in the three-year period through March 2015, with a median of 72% when measured against their appropriate style indices. However, Morningstar found that 20% of the so-called active funds it evaluated had three-year average active shares of below 60%. To all intents and purposes, these funds are closet trackers.
Interestingly, the peak in closet indexing coincided with the the global of financial crisis, with the proportion of closet indexers nearing 40% in 2008.
Matias Möttölä, Senior Manager Research Analyst at Morningstar and one of the authors of the report, said in a statement: “Average active share levels dropped considerably during the financial crisis of 2008 and 2009 but have been rising at a steady pace since then. In Europe we’ve witnessed increasing scrutiny from regulators in many countries, which could lead to structural change and less closet indexing in the market.”
However, Möttölä warns that investors using active share as a fund selection aid should be careful. This is because as active share increases, dispersion in returns and risk levels rises sharply, with both the best- and worst- performing funds found among the more active funds.
“It is the portfolio managers’ skill in selecting the right deviations from the index that generates outperformance. Among the least active funds, we found that almost all closet indexers underperformed their benchmark. If combined with high fees, such a fund is rarely a good choice. Investors should compare fees carefully as funds with similar active shares can have fees that differ greatly. We believe active share is best used only in combination with other quantitative and qualitative tools,” he said.
The Morningstar report looked at how active share has developed over a 10-year period to 2015, for the Morningstar Categories Europe Large-Cap Value Equity, Europe Large-Cap Blend Equity, and Europe Large-Cap Growth Equity, consisting of European large-cap funds investing in European equities.
Authored by Senior Manager Research Analysts Mathieu Caquineau, Matias Möttölä, and Jeffrey Schumacher, it examines active share in Europe from several perspectives, including historical changes in active share, the relationship between active share and performance and active share and risk, and the role of active share in fund selection. It comprises proprietary holdings data for European funds collected by Morningstar since the early 2000s.