Investing differently from the benchmark is a prerequisite in order to beat the benchmark. However, as our study on active share in European equity funds indicates, funds that differed drastically from the benchmark did not necessarily achieve better returns than funds managed with a benchmark-aware approach.
Furthermore, we found strong evidence of increasing risk as active share rose. Especially for funds with very high active shares, we observed higher volatility (standard deviation) and much larger drawdowns. As a result, while high active share funds can yield fantastic results for investors, they can also turn out to be a nightmare.
Our analysis focuses on long-only non-index funds sold in Europe and competing in the three European large-cap Morningstar categories: Europe Large-Cap Value Equity, Europe Large-Cap Blend Equity and Europe Large-Cap Growth Equity. To analyse the relation between active share and risk-return measures, we selected funds from these categories that had a track record going back to at least Jan. 1, 2010.
Active share: Positive and negative returns
The scatter plot graph below combines funds' five-year average active shares with their five-year annualised excess returns against each fund's Morningstar Category benchmark over the five-year period ending June 2015. As active share rises, the dispersion in results grows almost in an exponential fashion. The best and the worst performers are among the most active funds.
For funds with an active share below 60%, the dispersion in annualised excess return ranged from 4% to -5% versus their respective benchmarks. Still, the large majority of funds were plotted relatively tightly together. In stark contrast, among funds with an active share above 60%, excess returns ranged from 6.7% to -11%. The results remind us that it is not the degree of deviation that determines the level of outperformance, but the quality of active positions in the portfolio.
No return without risk
As all investors should know, returns go hand-in-hand with risk. How do these large return differences then affect funds' risk levels?
The most typically used risk metric is standard deviation, which we measure from monthly return data over the five year period ending June 2015. The scatter plot below indicates that no clear relationship exists between active share and standard deviation. Only the most active funds in the 90% to 100% active share bucket posted a markedly higher standard deviation on average. Investors should be aware of the possible higher risk involved when investing in funds that strongly deviate from the benchmark.
Standard deviation is one definition of risk, but it does not differentiate between positive and negative deviations. Looking at maximum drawdowns can also shed light on the risk taken by investors as they invest in high active share funds. The funds in the sample on average reported a maximum drawdown of -20.8% over the five-year period.
As was the case for excess returns, the span of outcomes in terms of drawdowns was very wide. The lowest maximum drawdown was -5.1%, while the fund with the biggest decline suffered -38.5% from peak to trough. The scatterplot below indicates a pattern of increasing maximum drawdowns as active share rises. For investors, this means that by selecting a fund with a higher active share increases the possibility of experiencing larger losses.
Be aware of style exposures
Our research demonstrates that funds with a higher active share exhibit different style factor exposures than their respective category benchmark. This can be in terms of sector, style or market cap exposure. For example, we found that funds with high active shares use small caps to a much larger extent than funds with lower active share. This could partly explain the elevated risk levels we observed previously for very active funds. Although this is not inherently wrong, investors have to be aware of such deviations and they need to make sure that no unintended style bets are taken.
Due to their strong deviation from the benchmark, investors selecting highly active funds can end up with funds that invest differently than they would expect. It is therefore crucial that investors investigate what factors drive the active share of a fund, and what kind of implications that might have for the expected performance and the level of risk involved.
