photo by Wagner T. Cassimiro "Aranha"
You may have missed an announcement from the New York attorney general’s office recently.
No, I’m not talking about the scandal that toppled Eric Schneiderman or one of Schneiderman’s many salvos against the Trump administration. I mean the office’s announcement in April that it had reached an agreement with 13 mutual fund companies to publicly disclose their funds’ active share.
Active share is a measure of the difference between a mutual fund’s portfolio and the contents of the fund’s benchmark index, expressed as a percentage. If there is no difference between the fund’s portfolio and the index, the active share is zero. Investors who pay more for active fund management presumably expect the active share to be higher. A small active share raises the question of why an investor would bother paying a premium for active management, rather than holding a lower-cost index fund.
“Closet” index funds are actively managed mutual funds that oversee index-like portfolios at prices significantly higher than real index funds. They may slightly overweight or underweight certain stocks or sectors, but their investment returns are closely aligned with their benchmark indexes, with no real possibility of significant outperformance. In fact, over the long term, they tend to lag their benchmark because of high fees. Active share is a useful data point for investors trying to steer clear of such funds.
Mutual fund firms often disclose active share information to institutional investors. But prior to this agreement, most of them did not make the same data available to individual investors, creating an information gap. Fidelity was the only firm of those surveyed by the New York attorney general’s office that routinely made active share information available to retail investors.
Most of the 13 firms who have agreed to this change, including big names like BlackRock, T. Rowe Price and Vanguard, will start posting active share data this spring. The attorney general’s office called on all mutual fund firms to voluntarily follow suit. While Schneiderman is gone, this agreement is likely to remain in place; it is hard to imagine that his successors have any real incentive to dislodge it.
Shining a bit more light on active share will be a good thing for retail investors. Funds are already required to disclose all kinds of data, and adding active share to the list should not create an undue burden, especially since it is information many fund companies already have.
That said, is active share useful? It depends on who you ask. Russ Kinnel, the director of manager research at Morningstar, found in 2016 that active share displayed no meaningful ability to predict performance. And some critics of the decision to report active share data to retail investors warn that it could encourage portfolio managers to take greater risks merely to boost their score.
Personally, I think that knowing different funds’ active share information can give investors a better understanding of what they are actually paying for before they decide to invest. It is certainly not the only data point they should consider, but if the information were useless, institutional investors would not be requesting it as often as they do. The fact that so many large mutual fund firms agreed to make this change without digging in for a serious fight is also telling. In general, more data for those individual investors who want it is not a bad thing. And while the Securities and Exchange Commission does not require fund companies to disclose active share across the board, perhaps the New York attorney general’s action will prod the SEC to consider doing so in the future.
A high active share alone is no guarantee of good fund management. A fund could differ widely from its underlying index because the fund manager is making all sorts of bad decisions, for instance. But monitoring active share can help investors avoid the trap of index funds dressed in active funds’ clothing.
In our current political environment, rule-making often seems little more than a way to score points against the rule makers’ rival party. It is refreshing to see that they can still produce a common-sense fix that helps investors too.