How Active Are the Biggest Active Foreign Funds?

In recent weeks we've been discussing the active share metric, as well as its uses and abuses. If you don't know what active share is, I'd recommend reading our earlier articles on active share among the largest domestic large-cap funds or the follow-up, in which we examine active share among domestic large-cap funds with different size asset bases as well as the relationship between active share and performance.

Along the way we've also heard some criticism of the active share metric. For one, active share isn't terribly useful in the absence of other metrics for context. Also, as suggested by this Fidelity study, active share can be subject to bias--in particular the fact that large-cap funds can differentiate their portfolios from their benchmarks and get a performance boost by investing in small-cap stocks. We've also heard numerous requests from readers to add active share as a metric on Morningstar.com, something we will certainly consider for future upgrades to the site.

One thing active share is undeniably good for is providing a snapshot look at how a fund's portfolio compares to that of a given benchmark. A fund with an active share close to 100 bears almost no resemblance to its bogy, while one with an active share closer to 0 is nearly identical. Whether this resemblance, or lack thereof, has any bearing on performance is another matter entirely. However, given that fund investors generally pay higher fees for exposure to active management than they would by owning a comparable index mutual fund or ETF, it's only natural to wonder just how different a fund's portfolio is from its benchmark's.

Having already looked at active share among the largest domestic large-cap funds, we thought it would be worthwhile to see how it compares among the largest foreign large-cap funds. As our benchmark, we used the MSCI All Country World Ex-USA Index, which Morningstar uses as its benchmark for the international equity category group. Using the MSCI EAFE Index also was an option, but it does not include emerging-markets exposure, which MSCI ACWI Ex-USA does. It's also a very broad index, made up of more than 1,800 stocks in 45 developed and emerging markets outside the U.S. The index is market cap-weighted and has a foreign large-blend orientation, with less than 10% mid-cap exposure and virtually no small-cap exposure.

How would the 20 largest actively managed foreign large-cap funds stack up against this broad benchmark? Here are the results. 

The spread from top to bottom here is rather wide, from  Artisan International Value (ARTKX) and its active share rating of 94.3 to  Strategic Advisers International (FILFX) at 65.7 (all readings are as of June 5). As with our domestic large-cap active share exercise, we see no clear pattern with regard to the foreign large-cap categories--foreign large-blend, foreign large-growth, and foreign large-value funds are represented up and down the list.

We also see a rather impressive group of star ratings, with 15 out of the 20 largest actively managed foreign large-cap funds sporting 4 or 5 stars based on their past performances. What's more, these better-than-average star ratings can be found among the highest and lowest active share funds, although all the 5-star funds here--those that were top performers--had active share ratings of 83 or more.

To illustrate how active share alone can be deceptive, look no further than  Dodge & Cox International Stock (DODFX) and  Thornburg International Value (TGVAX), both of which sport active share ratings of 83.4. Yet the former is a 5-star fund while the latter is a 2-star fund. Both funds are well-regarded by Morningstar's fund analysts, but the Thornburg fund has suffered from poor recent performance. (Also keep in mind that active share looks at a fund's portfolio on a specific date whereas the star rating encompasses up to 10 years of performance.)

Also of interest is the relationship between the number of holdings in each fund's portfolio and its active share. The highest active share fund, Artisan International Value, is the most concentrated fund on the list with just 55 holdings. Several others with fewer than 100 holdings land in the top half. Clustered at the bottom are the more diversified funds, including three with more than 400 holdings apiece.

As we saw with domestic large-cap funds, these active share numbers would seem to suggest that differentiating a portfolio from its benchmark becomes more difficult the more diversified the portfolio is. However, running a concentrated portfolio carries its own risks. The fund manager must have higher conviction in his or her stock picks, while added concentration may also bring added volatility in performance. Anyone can assemble a basket of stocks that looks remarkably different from a benchmark. Getting the formula right with a portfolio that outperforms is the hard part--and, indeed, the more important issue for active fund investors.

Other Ways to Assess Active Management
It bears repeating that while active share isn't currently available on Morningstar.com (the numbers above came from Morningstar Direct, a platform designed for financial institutions), there are ways to assess how your fund's portfolio relates to that of its benchmark. One is by examining the fund's R-squared--found under the Ratings & Risk tab on the fund report pages--which measures the extent to which the fund's up and down movements can be attributed to the benchmark. Also, you could take a look at the fund's year-by-year performance relative to its benchmark. If you find that it tends to lag by a percentage point or two year in and year out, it could mean your fund is guilty of being a benchmark-hugger.

Yet another idea would be to compare the fund's portfolio with that of a fund tracking its benchmark. For example, click on the Portfolio tab for your foreign large-cap fund and compare it with the Portfolio breakdown for  iShares MSCI ACWI ex US Index ETF (ACWX), an ETF that uses the benchmark we've used in our active share calculation here. Or, if your fund has minimal emerging-markets exposure, you could use  iShares MSCI EAFE ETF (EFA), which tracks an index of developed markets outside the U.S. Once you've examined the breakdowns by market cap, sector, and world region, click on the Holdings tab to see how similar your fund's top holdings are to those of the benchmark (or the fund tracking it). If they look more alike than you'd expect--and are willing to pay extra for--perhaps you should think about using an index fund instead.