These funds are getting less active.
When purchasing an actively managed mutual fund, investors want to make sure they're getting their money's worth. Active managers on average charge higher expenses than passive products, such as index mutual funds or exchange-traded funds, and, accordingly, their funds' portfolios are expected to be distinct from their bogies, with a better chance of outperforming their benchmark. There are several metrics that can help investors evaluate how distinct their funds are, from returns-based statistics such as R-squared, to those based on holdings, such as active share (for more background on active share, check out this article). When these metrics show an active fund is becoming more correlated with its index, it can be a warning sign to investors that their fund may be losing some of its edge.
Recently, a few funds stood out with a decreasing active share, indicating a higher percentage of their portfolios now overlap with their respective index. While these funds may not be transforming into closet index-huggers, a closer alignment with their index can be a tip-off for investors that the active portion of their own portfolio is decreasing.
Large-blend fund Vanguard Growth & Income VQNPX is one example of a portfolio that is becoming more like its S&P 500 Index benchmark. In 2011 the portfolio's active share was cut roughly in half, clocking in at around 27% as of June 2012 relative to the index, one of the lowest among active large-blend managers. A subadvisor switch is the reason behind the change. In September 2011, Vanguard replaced subadvisor Mellon Capital with a trio of teams. Los Angeles Capital Management, D.E. Shaw Investment Management, and Vanguard's quantitative equity team now each manage an equal-sized portion of the portfolio, using quantitative models to benchmark their risk levels against the S&P 500 Index. After the management change, the number of holdings in the portfolio ballooned from roughly 150 to more than 750 stocks. On the plus side, the fund's fees are so low that it only needs to make up about 15 basis points to pull even with Vanguard 500 VFINX.
A similar shift occurred in the portfolio at USAA Aggressive Growth USAUX in July 2010, when USAA replaced manager Tom Marsico with subadvisors Wellington Capital and Winslow Capital Management. The fund previously held a fairly concentrated portfolio of roughly 50 stocks but grew to around 130 stocks after the new subadvisor duo came on board. The fund's active share decreased by more than 20 percentage points between the second quarter of 2010 and early 2011, confirming the additional holdings shifted the portfolio to more closely align with the fund's Russell 1000 Growth Index benchmark. As of June 2012 the fund's roughly 56% active share was well below its average peer's 73% active share.
Even if the firm running the fund stays the same, a change in lead manager can also shift a fund's portfolio significantly, as seen at Neuberger Berman Large Cap Value NPRTX. In December 2011 Eli Salzmann took the fund's helm, and while the number of holdings remained mostly the same, at around 80 stocks, the fund became much more closely aligned with its Russell 1000 Value Index holdings, as the active share dropped to 60% from roughly 78% between the third quarter of 2011 and second quarter of 2012, landing below its average peer's 72% active share for the first time.
While these changes alone may not necessarily be a bad thing--volatility may decrease at the funds, for example, as a portfolio becomes more diversified--the changes indicate the funds may have less of an edge against their indexes going forward. Keeping an eye on metrics such as R-squared and alpha will confirm what type of performance effect these changes will have over time and should help investors decide if the funds still fill a needed active role in their own portfolios.
This article originally ran in the July 2012 issue of Morningstar FundInvestor.