Mutual fund selection is difficult. Most fund-houses offer three to four equity funds that are prima facie no different from each other. The confused investor typically buys equal units in all these funds. Such a strategy is not optimal, a topic that was discussed in this column in the article titled “Diversification or Di-worse-ification?”
The problem extends beyond this. Some active funds mirror the benchmark index. Such funds are called Closet Indexers. Investors should avoid such funds, as they are simply index clones charging fees for active management.
There is a case for mutual funds to disclose a statistic called Active Shares. This measure enables investors identify such closet indexers. Active share simply captures the active bets taken by a portfolio manager. Higher active share means that the portfolio manager is striving to generate alpha returns.
Take HDFC Mutual Fund. This fund-house offers three diversified equity funds — Growth, Capital Builder and Equity. As the investment objectives of all three funds are “to achieve capital appreciation”, it would be difficult for an investor to discern differences, that would help to pick and choose between them. Mutual is not the lone example. All fund-houses offer multiple products in the same investment space. This poses several problems for the investors.
One, an investor has no knowledge about the fund’s investment style. Suppose, one fund follows large-cap value, another follows large-cap growth and the third has a style drift (a changing style), the investor can then take exposure in all three funds to take advantage of style diversification. But what if all funds follow similar styles? Spreading money across different funds would then be sub-optimal.
Two, as funds expand in size, the portfolio managers typically become defensive. The reason is that investors do not take kindly to fund managers underperforming the index. This forces fund managers to construct portfolios that hug the index. If the fund loses value, investors draw solace from the fact that the fund manager has only lost as much as the index!
The problem is that such closet indexing also means sacrificing upside potential. Importantly, closet indexers charge active fees for market (beta) exposure.
Mutual funds should be more specific about their investment style in their monthly newsletters and offer documents. Funds with multi-style investing should state as much, so that the investors know the risk associated with style drift.
Disclosing investment style also helps investors in choosing appropriate benchmarks to compare fund performance. Funds with style drift can choose a broad-based benchmark such as the S&P CNX 500.
Such benchmarks help investors identify closet indexers. Take Reliance Equity Advantage Fund. It has an expense ratio of 1.89 per cent, usual with actively managed funds.
If we use the measure called R-squared to capture the relationship of the fund’s return has with the index return, the Equity Advantage Fund has an R-squared of 0.98. This means that 98 per cent of the variation in the fund’s returns can be explained by the changes in its benchmark index.
This suggests that this fund is largely mirroring the index performance, even if is taking any active bets. Of course, the fund is less than a year old- too young for performance attribution analysis. Yet, an investor can just as well invest in an index fund with an expense ratio of less than one per cent.
The excess return that an active manager generates over the benchmark index is termed alpha. Fund managers cannot consistently generate alpha. Take HDFC Capital Builder. This fund marginally underperformed the benchmark on a one-year and three-year horizon but generated sizable alpha over a five-year period. Investors can thus choose managers who take active bets and be willing to bear the risks if such bets turn wrong.
Active share is a measure that captures a portfolio manager’s alpha bets. It captures the proportion of active bets as a percentage of the benchmark and the cumulative weights of all such bets.
Suppose the benchmark index has 50 stocks and the manager has taken active bet (overweight) on 20 stocks, the active share is 40 per cent (20/50).
The fund manager can also invest in the same stock as the benchmark index but vary the weights. Suppose Reliance Industries has 10 per cent weight in the index but the fund has 15 per cent exposure, the active share is 5 per cent. Active share, thus, can vary between nil and 100 per cent for long-only portfolios.
Closet indexers will have very low or near-zero active shares. Empirical evidence shows that active funds with high active shares and large tracking error generate alpha returns.
Fund-houses should provide meaningful measures to allow investors to understand their investment style. This may help investors identify closet indexers and alpha generators. SEBI and AMFI should urge fund-houses to provide such measures in their monthly newsletters.
B. Venkatesh
(The author is an investment strategist. He can be reached at enhancek@gmail.com)
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