There are few things that active and passive investors agree upon, but you won’t find too many people on either side of the aisle who supports closet indexers. Pretty much everyone is in full agreement that mutual funds that look like their benchmark and charge high fees should disappear yesterday.
If you are going to pay higher fees than the index, you want the fund’s holdings to meaningfully differ, this way it has a chance of beating it. But it turns out that a high active share- how different a fund is from the index- is not predictive of higher returns. Here’s Morningstar’s Russ Kinnel on the trouble with active share:
The quintile with the highest active share among U.S. equity funds had a meager 29% success ratio, followed by 27% for the second quintile, 32% for the middle quintile, 40% for the fourth quintile, and 43% for the least-active quintile.
He then goes on to compare how influential active share is in determining returns compared to how cheap the fund is:
For the sake of comparison, the cheapest quintile of U.S. equity funds had a success ratio of 64% versus 16% for the priciest quintile. The high active-share quintile’s 29% success ratio was comparable to the 28% success ratio registered by the fourth (or second-priciest) quintile of fees.
It’s not that active managers can’t add value, it’s that figuring out which ones will is extremely difficult. Furthermore, sticking with a manager that does add alpha during a period of underperformance might be more challenging than finding them in the first place.