How active is your fund manager?

When I’m choosing between brand-named aspirin and the generic alternative, I almost always opt for the latter. Both painkillers share the same major ingredients, but the generic competitor is usually a lot cheaper. That said, I’d be willing to pay a (small) premium if the brand-named product is longer lasting, easier on my stomach, or more effective.

Fund investors face a similar choice between active and passive management. Many active managers fear impatient investors (or employers) will fire them if they underperform and limit the risks they take versus their benchmarks. As a result, active and passive portfolios are made of similar ingredients. If the portfolios look alike, the cheaper, passive option appears like the easy choice.

Not every choice is as simple. Nominally active funds could still stand decent odds against their benchmarks if their price tag is low enough. Higher-cost funds may yet outperform if their portfolios are distinctive enough. Fees are the most reliable guide to a fund’s prospects, but investors should consider not only what they’re paying but what they’re getting. As Warren Buffett put it, “price is what you pay, value is what you get.”

“Active cost,” a concept developed by academics Martijn Cremers and Curtis Quinn, is one way investors can quantify the bang they get for their actively-managed buck. The measure compares a fund’s MER, less the cost of the passive alternative, to its active share (eager investors can see the calculation below).

Active share, describes how different a portfolio is from its benchmark. (Cremers introduced active share along with Attni Petajisto in 2006.) The higher its active share, the less a fund looks like its benchmark. A fund that replicates 75% of its benchmark’s holdings would have 25% active share, for example, while a fund with 25% overlap would have 75% active share. If both funds have 1% MERs, the latter offers better value per unit of activeness.

I’ve calculated active cost across the Canadian Equity category using the MER of each fund’s lowest share class—almost always the commission free, fee-based series. (Many investors hold the more expensive commission-based series, but I wanted to exclude advice and distribution costs from the mix.) I used the Morningstar Canada index as my active share benchmark. Just as the unit price listed on grocery shelves enables shoppers make meaningful comparisons across brands, active cost helps fund investors spot good values across an investment category.

Take RBC Canadian Equity, for example. At first blush, its 0.95% MER appears reasonable next to the 1.11% median for its fee-based distribution channel. But the fund’s largest holdings resemble those of its benchmark, the S&P/TSX Composite index, resulting in 29% active share—one of the category’s lowest. As a result, its active cost of 3.2% ranks among the category’s highest. This number implies management needs to wring 3.2 percentage points of added value from a small slice of the portfolio to overcome its fee hurdle. That’s a hurdle even Warren Buffett would struggle to clear. Low-cost passive options like iShares Core S&P/TSX Capped Composite, which levies a 0.06% MER, a better bet.

By contrast, Pender Canadian Opportunity’s 1.4% MER makes it one of the most expensive funds in its category. But lesser-known stocks like Medicure and Absolute Software headline its portfolio, giving it the group’s second highest active share of 90%. With an active cost of 1.5%, the fund looks like a better deal than its RBC peer. Also, with an ultra-small $5.8 million asset base, the Pender offering enjoys far more flexibility than its $2.5 billion rival.

Active cost also can help investors weigh competing factor-based, or “smart beta,” strategies and compare them to traditional actively-managed funds. These funds tilt their portfolios toward factors historically associated with above-average returns, such as size, value, volatility, or momentum. Sometimes this tilt is modest. DFA Canadian Equity and iShares Canadian Fundamental Equity ETF favour stocks with low valuations, but with active shares of 26%, they still look a lot like the benchmark. With almost identical active shares, it’s easy to spot which option provides more active share for the buck. The DFA fund’s 0.34% MER clocks in well below the iShares ETF’s 0.73% levy. Even the more expensive iShares offering is still a better buy than even pricier RBC Canadian Equity.

As a snapshot in time, active cost often paints an incomplete picture. PH&N Vintage’s active share stands at 48%, but it’s typically fluctuated from 40% to 60%. Knowing when to make active bets has contributed to management’s strong long-term record. With a middling 1.14% MER, the fund’s current active cost of 2.3% is somewhat high by category standards. But competitors with lower active costs probably won’t replicate the PH&N offering’s process. The apparently better value may be a mirage.

Of course, active cost is only one way to assess value. Other attributes matter too. A fund without capable management and a sound process isn’t much of a value at all.

Active cost of Canadian mutual funds

Active Share Benchmark is Morningstar Canada
IndexData as of March 31, 2017

Active cost calculation

Active cost=(MER_fund-PassiveShare_fund*MER_passivefund)/ActiveShare_fund
where “passive share” is 1-ActiveShare_fund

Christopher Davis oversees Morningstar Canada’s manager research team as a strategist. In addition to overseeing Morningstar’s Canadian thought leadership agenda, he leads Morningstar Canada’s Analyst Ratings Committee. He also represents Morningstar on the Canadian Investment Funds Standards Committee. Davis holds a bachelor’s degree in economics and political science from the University of Illinois Urbana-Champaign.