Fidelity fights back against ‘active share’

Fidelity Investments is fighting back against active share, a concept picky professional investors are increasingly using to select fund managers.
Tim Cohen, chief investment officer at Boston-based Fidelity, said in an interview that professional investors are treating active share as a “magic number” that tells them which funds to buy and sell.
“Like anything else in life, people want to oversimplify complex problems or complex situations,” said Mr. Cohen, whose business unit manages $2 trillion in assets.
“We don’t think active share is predictive of outperformance,” said Mr. Cohen. “We’re worried that the publicity and hype around this is actually leading investors into funds that don’t have the right risk tolerance for them.”
Mr. Cohen’s group has taken its argument on the road, and published a white paper on the topic in February.
The paper challenges the orthodoxy that has developed around the concept of active share since the measure was proposed as predicting a fund’s future performance. That argument came in a paper by two prominent academics, Antti Petajisto and K.J. Martijn Cremers.
Active share is the percentage of a fund’s holdings that differ from a benchmark index.
In the six years since that argument was published in the Review of Financial Studies, the concept has come to dominate third-party evaluations of fund managers, according to several industry figures interviewed for this story.
COMMON LINGO
“It wasn’t that long ago that you could talk to people and they weren’t that familiar with the idea and hadn’t heard of it,” said Tom Brakke, an industry consultant on fund-manager due diligence. “That’s very rare now. It’s the lingo that everyone talks about.”
Now, the second-largest U.S. mutual fund manager says the industry has gotten carried away. Officials like Mr. Cohen argue that active share is not a proxy for manager skill or their potential for outperformance. Worse, high active share may increase performance risks or indicate that a manager is deviating from their stated objectives, a phenomenon called style drift.
While other managers, such as the Vanguard Group Inc., have also questioned some elements of active share, Fidelity is making the most forceful case among large firms.
The overwhelming approach of those active asset managers, from Pacific Investment Management Co. to Natixis Global Asset Management, has been to embrace the concept and to market their fund lineups accordingly.
“We’ve actually become, over the last three years, big proponents of using the metric both in terms of due diligence and in terms of the sales process,” said David Lafferty, chief market strategist at Natixis, a $890 billion fund manager based in Paris and Boston. “When someone does due diligence on an active manager it’s not the end-all, be-all, but it’s a great statistic to talk about your conviction to outperform, net of fees.”
Mr. Lafferty said Natixis uses active share to evaluate fund managers and is exploring using the number in marketing documents distributed to financial advisers.
TRILLIONS AT STAKE
At stake in the argument over active share are trillions of investors’ dollars and the future of active management.
Investors are becoming more selective in their use of active managers, driving money to index-tracking funds. Actively managed domestic equity mutual funds lost $575 billion from 2007 to 2013, while index funds and ETFs, which are primarily benchmarked, gained $795 billion, according to the Investment Company Institute, a fund industry trade group.
“We avoid closet indexers — if you want an index you can get that for cheap,” said Ben Francois, president of Canterbury Consulting, a manager-research specialist based in Newport Beach, Calif. His firm prefers managers that build small, or “concentrated,” portfolios that take big bets.
Fidelity’s stance comes as that firm looks to stanch investor redemptions of its actively managed funds. The firm’s managed accounts and funds had $6 billion in outflows in 2014, the firm disclosed in February.
Fidelity describes investor interest in index funds as a “cyclical” trend.
But the advisory industry’s use of active share may also be contributing to those disappointing results. The use of active share as a factor in fund selection is “pretty close to universal in the intermediated market,” said Fidelity’s Mr. Cohen, referring to research teams that serve broker-dealers and other professional investors.
One who has popularized active share said the measure remains a useful tool as a “starting point” for investors.
NOT A GUARANTEE
“Having a high active share is often a precondition for outperformance, but it’s not a guarantee,” said Mr. Cremers.
Mr. Cremers’ co-author, Mr. Petajisto, is now a portfolio manager at BlackRock Inc. A BlackRock spokesman, Ed Sweeney, said the firm would not make Mr. Petajisto available for an interview.
Mr. Cremers said the concept has helped to reduce the trend of closet indexing, where managers charge high fees while effectively tracking a benchmark.
“More and more advisers or end investors are asking companies about the active share, and I think more people are concerned that they’re buying a closet indexer,” said Mr. Cremers, now a professor at the University of Notre Dame. “The issue for Fidelity is that many Fidelity funds do not have high active share.”
At Fidelity, stock funds currently average an active share of 72.5 out of 100, below its peers, who average 82.1, according to an analysis conducted for InvestmentNews by Morningstar Inc. A higher number indicates greater difference from a reference benchmark.
Fidelity’s largest fund, William Danoff’s $112 billion Contrafund, scores a 61.2 for its portfolio as of Jan. 31. Other large-cap growth funds average 76.2. The fund is the largest source of the firm’s outflows. It bled $12.7 billion in the year that ended in February, Morningstar estimates.
(Morningstar’s active-share analysis compared the holdings in the most recent portfolios for every open-end mutual fund against the common Russell Investments benchmarks representing each of nine investment-style boxes, except “large blend.” In that case, the firm used the S&P 500 as the reference benchmark.)
Mr. Cohen said “it’s too bad” if potential clients are screening out his firm’s funds because of active share. He said his firm has extensive data on active share and that Fidelity funds are “not in the lower end.”
But the trend toward active share may be just getting started, posing threats to established fund managers.
A Swedish shareholder-advocacy group has even initiated the rough equivalent of an arbitration complaint against a fund company for closet indexing.
The chief executive of the Swedish Shareholders’ Association, Carl Rosen, told InvestmentNews his team used active share to develop its case.

Related Topics: BlackRock Inc., Fidelity Investments, Morningstar Inc., Russell Investments, Vanguard Group