Dare to be Different

Investment managers are generally split into two categories: Active and passive. Active managers aim to outperform a certain benchmark index by being different from it. Passive investors seek to replicate an index. Both have their proponents and their detractors. Recently there has been a strong trend towards passive investment following a number of studies which show that the average passive fund has outperformed the average active fund after costs.

Active managers are not all the same though, and it’s a mistake to lump them all together. One of the most important differentiators of an active manager is active share. Active share is a measure of how different a portfolio is from a benchmark index. Active share is calculated by summing all the absolute differences between a portfolio’s position weightings and the benchmark’s position weightings, and dividing by two (because you’re double counting). A portfolio with an active share of 0% is replicating the index exactly – i.e. passive investing. A portfolio with an active share of 100% has absolutely nothing in common with the benchmark index. The higher the active share the more different a portfolio is from the benchmark – the more active it is.

Why is Active Share so Important?

Much of the active management industry purports to be active, charging active fees, but delivering portfolios with low active shares (i.e. <60%). These funds are closet indexers. They are a major reason why active management as a whole has lagged passive. If you hold a closet index fund, your gross return will be roughly the same as the index, but your costs will be higher than an index fund. This all but guarantees underperformance. There really isn’t any good reason to hold a closet index fund.

In contrast, truly active funds (those with active shares >80%) have outperformed their benchmarks in aggregate over long periods of time. This was demonstrated by Antti Petajisto in his paper Active Share and Mutual Fund Performance. There is a very real place for true active management – investment which demonstrates genuine conviction. Why is this so? Perhaps the most skillful investors are more likely to have conviction in their processes, so they tend to have higher active shares.

Unfortunately there isn’t much of this type of active management about. Between 1980 and 2009, the proportion of truly active US mutual fund assets dropped from 60% to less than 20%. According to a 2016 Morningstar paper, less than a quarter of actively managed European equity funds fell into this category. Only 2.4% had an active share of more than 90%. Why?

If high active share tends to outperform over time and closet indexing does the opposite, why has true active management shrunk over time? Because, in the short-term, high active share is a double-edged sword. Short-term returns are highly random. High active share guarantees periods of significant underperformance, even for the most skillful investor.

These periods are difficult for investors and investment managers to deal with. There are all kinds of emotional biases that mistakenly attribute randomness to skill or lack thereof. Despite the fact that closet indexing practically guarantees long-term underperformance, investors are far more likely to give up on an outlier in the short-term – i.e. a truly active manager.

Avoid the Middle

Far too much attention is given to outliers by advisors, investors and the media every quarter and every year, both on the downside and the upside.  There is simply no acknowledgement of the role that randomness plays in short-term outcomes, especially where active share is high. Distracted by the outliers, they ignore those hiding in the middle. Closet indexing is an easy way to survive as a fund manager once you’ve built up a sizeable fund. It ensures you’ll be consistently in the middle of the pack. Sadly, it is this group as a whole that adds no value to the end investors. This issue deserves far more attention, from advisors in particular. Charging active management fees for tracking an index is a great disservice to investors.

One indication of closet indexing (other than low active share) is a portfolio of household names that tends to track the market. There are 1 000s of relatively unknown, but still significant businesses listed around the world. One shouldn’t expect a sound active process to yield only familiar names.

For us there is simply no point in being a closet indexer. Passive investing delivers the same result before costs, but at lower cost. Closet indexing, while comfortable for some, is obsolete. What makes sense is to either be a true active investor, a passive investor, or to combine products at either end of the active share spectrum.

Analyzing our Active Share

Bellwood Capital’s active share is 95% relative to the MSCI World Index. We hold 49 different shares across all of our portfolios, vs roughly 1 600 in the benchmark. 20 of the shares we hold, comprising 43% of our portfolios, are not in the benchmark. The other 29 shares / 57% of our portfolios contribute just 6.5% to the MSCI World Index. Our portfolios are truly different from the index on an individual stock level. The returns they generate will also be different from the index. This is a good thing (though it might not always feel like it).

So why are we so different from the index? Are we being different just for the sake of it, or does being different add value? While Petajisto demonstrates that being different does add value on average over time, high active share isn’t a panacea that can stand in place of a sound investment process. High active share should be the result of a good process. It is important to get the cause and the effect the right way around.

Our approach is to build diversified portfolios of our best ideas from the available opportunity set. To achieve diversification doesn’t require much more than 30 – 50 stocks, provided they aren’t all exposed to the same industries and geographies (more on this lower down). Within this framework, we maximize exposure to our best ideas in terms of profitability, financial strength and valuation – the three causal drivers of return. The end result is likely to be very different from the benchmark. This is true active investment management, demonstrating a high level of conviction in our process.

Midcap vs Megacap

One theme seems to stand out when we examine the nature of the differences between our portfolios and the benchmark: Market capitalization. More than half of the index is invested in about 200 companies each with a market cap of more than $50 bn. Only a quarter of our portfolios is invested in a dozen of these 200 stocks. Further, we have a very significant weighting (about 40%) in midcap companies with a market cap of less than $10 bn. These are still very significant businesses. The index has less than 10% in these stocks. While we don’t generally prefer midcap companies, we do see more abundant opportunities among these stocks than the megacap stocks, as they are currently priced.

This comes as the trend towards passive has accelerated in the last few years. It is expected that assets invested in passive US equity funds will surpass their actively managed counterparts for the first time ever in 2019. In 1995, less than 5% of US equity assets were passively invested. The tidal wave of money flowing from active to passive in the last few years, and to the S&P 500 in particular, has meant that the megacap companies on which passive investing is generally focused have been bought indiscriminately at the expense of midcaps that don’t feature in the popular passive indices. This doesn’t make these businesses inferior investments, but it does mean that many are a lot cheaper than they’ve been in the past, especially relative to the megacap stocks.

Mind the Valuation Gap

Our portfolios are currently trading at their 5th percentile of historic valuations relative to the MSCI World Index. The valuation gap between the index and the stocks we currently hold is as wide as it’s ever been. This is a good reason to be different from the index, because valuation is a key causal driver of long-term returns.

By our estimates, the popular passive indices are not priced for good long-term returns, and no wonder given the massive indiscriminate flows in their direction the last few years. We’re quite happy to be different in this regard.

Applying Active Share to Diversification

While 49 stocks is undoubtedly diversified on an individual company basis, it doesn’t help if these are all in one or two industries or countries. There is another way to apply active share that helps to assess whether we are adequately diversified in this regard, or whether we are taking large industry or geographic bets*. We generally avoid these because they don’t have strong causal links to return.

The way to measure this is to calculate active share in terms of industry groupings and geographic groupings relative to a diversified index (like the MSCI World Index). Lower active shares on these measures indicate greater diversification. Ideally we would want our portfolios to exhibit high active share on the individual stock level, but low active shares at the industry and geographic levels. Our active shares are 33% and 29% respectively at the industry and geographic levels. This indicates high levels of diversification. Combined with an active share of 95% at the stock level, these measures put us right at the business end of well-diversified active investing.

* Side note: Whilst identifying the desirability of high active share at the stock level, Petajisto also demonstrated how these types of “factor bets” haven’t added value to investors over time, though he measured this using tracking error. Our tracking error is between 5% and 6% – on the lower end of the spectrum – which is consistent with our industry/geographic active share measures.

Dare to be Different

True active investing is about consistently applying a sound process to build a diversified best-ideas portfolio. It is not supposed to track the market, and if it does there’s something wrong. This type of investing adds real value over time, but it isn’t always easy. Bellwood Capital is a truly active global investor. Our active share demonstrates this. In an environment of generally high equity valuations, driven by indiscriminate passive flows towards the major index constituents, we’re far more comfortable being different from the market than following it.