Having your cake and eating it

We’ve all experienced the bitter taste of getting something that fell short of what we paid for. Like any consumer, investors are just as susceptible to such disappointment. How to prevent this is one of the many discussions currently underway in asset management circles, in the guise of active share. But is this really an optimal way of establishing that fund buyers receive what they wanted or thought they were sold?

The measure of active share has been around for a while, but the significant attention it receives from regulators, consumer groups, and the media is a relatively recent development. Increased take-up of passive funds in Europe has resulted in the proliferation of a raft of much cheaper products, in turn leading fund buyers to question the value for money of active management. In its most basic form, active share determines what proportion of a given active fund’s allocation deviates from that of its benchmark. It is a crude tool; a manager may well decide to temporarily sail close to the benchmark if that represents the best conditions for short-term success, but as active share measures allocations at a specific point in time there is no way of separating the truly active wheat from the closet-tracking chaff.

It also takes little account of the size of individual positions. A portfolio consisting of a few large bets may well have a lower active share than one made up of many small bets. Furthermore, the pressure to avoid low active share could mean that active managers are forced to take on additional risk just when they don’t want to, resulting in poorer returns. I could go on – as with most statistical measures, multiple issues arise when it comes to applying it.

Regardless of the drawbacks, can active share achieve its objective? That is, do fund buyers get what they pay for? Let’s take the analogy of a cake. The cake in question is advertised as containing 100 grams of flour and 70 grams of sugar, and is mixed by hand (we may need to chuck in a few eggs for good measure, too). Do consumers care if, actually, the cake contains 90 grams of flour and 75 grams of sugar and the baker used a whisk? Not really. They care about the taste – that is why they bought it. It is the outcome that counts much more than the constituent ingredients. The same is true of funds – from the investor’s point of view, outcomes trump inputs. If a fund has an active share of just 30% but beats its index by a significant margin, this is still better than a fund with a 90% active share that underperforms.

Some of you may respond to this by saying that, unlike a precision-baked cake, there is no recipe for guaranteed results in asset management. You can measure out the ingredients but can’t quantify what they will become, and therein lies the benefit of analysing active share. You may also say that buyers shouldn’t be charged extra when there is no real chance of outperformance. Both of these statements are fair, and I’m not seeking to excuse active managers that track an index so closely as to leave no opportunity to outperform. However, to me, active share doesn’t seem to hit the value-for-money target at which it is aimed. It simply focuses on how the cake is made – even if it ends up tasting unpleasant.

The solution to this debate may prove unpopular with all parties. Just as the taste of a cake can only be known once you get around to eating it, the value of a fund can only be seen in its results. Consequently, the only true way to align price and returns is to charge a fee based on those returns – a performance fee. That way, those managers whose funds end up more of a saggy soufflé than glorious gateau – whether through benchmark hugging, a lack of skill, or incorrect positioning – get paid a much lower amount. The ingredients and the baking method are taken out of the equation. It would cost you more to get a cherry on that cake, but at least you’ll be paying less if your selected product is playing it safe.