Is your active fund manager truly 'active'?

star, is approximately 1.4 percent and so fund companies are earning over USD 120 billions per year in fees alone.

Investors pay such high fees because they think an active equity fund manager could generate a positive risk-adjusted return or alpha for them. There are two main sources for alpha: stock selection and market timing. Stock selection is about picking the best performing stocks and market timing attempts to predict future market directions.

Even though only around fifty percent of large- capitalization U.S. stock funds surpassed S&P 500 Index last year, a recent study by a pair of professors from Yale-Antti Petajisto and Martjin Cremers-shows that active managers perform better over long term especially when sector moves are not as frequent as last year. Sector move, also known as sector rotation, refers to situation where certain sectors find favour with investors at particular points in the economic cycle. For example, oil price rises affect all oil-company shares regardless of their respective earnings. If sector moves are frequent within a short period, it will be difficult for active managers with long-term investment strategy to generate alpha.

Since active fund managers can potentially outperform market benchmark, they charge higher fees than passive managers do. However, for investors, how can they tell if a particular fund is truly active and they are really getting their money's worth?

Traditionally, tracking error is used to measure active management. Tracking error is the volatility of the difference between a portfolio's return and its benchmark index return. The higher the tracking error is, more actively the fund is managed. However, the potential drawback of this approach is that investors would not be able to tell a fund's potential for generating a positive alpha. Tracking error by itself did not correlate to fund returns, which investors pay for.

Another useful way is holding based style analysis. Holding-based style analysis is a method used to identify and describe the characteristics of an investment portfolio by classifying a portfolio's underlying securities. The Morningstar Ownership Zone, one of the holding-based style tools, can help investors get those indexers out of the closet quickly by showing portfolio holdings in a nine-square grid, a.k.a Morningstar Style Box. The ownership zone reveals how much an active portfolio resembles to its benchmark index by plotting each underlying portfolio holding in the Morningstar Style Box. More overlapping holdings a fund has with its benchmark, less actively the fund is managed. For example, both Axa Rosenberg US Equity Alpha fund and Baring Main Street US fund use S&P 500 Index as performance benchmark. As shown in the graph below, Axa Rosenberg US Equity Alpha fund had more mid-cap exposure compared to the index while Baring Main Street US fund is more focused than the index.

Petajisto and Cremers use another way, active shares to compare the portfolio holdings of a fund to its benchmark. Active shares are defined as the shares of a portfolio's holdings that differ from the portfolio's benchmark index. Any non-zero fund alpha can only come from those active shares since they directly measures the fund's positions that deviate from the index. Therefore, they should be useful for investors in estimating the potential of a fund to generate alpha.

It might be too much to expect general investors to explore either how much tracking error or how many active shares their funds have. If you cannot tell if your fund manager is active or not, do not try to beat the market. Simply buy an index fund or another low-cost option, and sleep easy at night.