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02 A Discussion with Martijn Cremers, PhD

Mary Mock & Tim Paulin
Distinctively Active Podcast
Share:
Distinctively Active Podcast Episode 2
Martijn Cremers:
What we found in our research is that managers with low active share, especially those that are not inexpensive, substantially underperform on average in the long-term, and managers with high active share did not underperform.

Steve Graziano:
Welcome to Distinctively Active Investing, Profiles and Perspectives presented by Touchstone Investments. I'm Steve Graziano, President of Touchstone. On this show, you'll find out what makes Touchstone, its leaders, and its portfolio managers distinctive. We'll share in-depth interviews with the people who are actively engaged in leading and managing the Touchstone funds.

Mary Mock: Welcome. I'm Mary Mock, Divisional Vice-President for Touchstone Investments. On our last episode, you heard all about the life and career of Steve Graziano, the president of our company. Within that episode, we also discussed active share, and this episode is going to dive deeper into that topic.

Our guest is Martijn Cremers, who we talked about in episode one. He is Martin J. Gillen Dean and Bernard J. Hank Professor of Finance of the Mendoza College of Business at the University of Notre Dame. His 2009 academic research introduced us to the concept of active share. In April 2020, Martijn sat down with Touchstone's Tim Paulin. Here's Tim.

Tim Paulin:
I'm Tim Paulin, Head of Research and Product at Touchstone Investments. I'm joined today by Martijn Cremers. Martijn has become well-known over the course of the past decade based on his pioneering research in the area of active management. Martijn, what I'd like to do first of all, is to talk to you a little bit about that original research that you've done in active management.

Tim Paulin:
We believe that there are despite some debate in the investment community about its purpose and use, there are things about it that are inherently valuable. So, could you give us a little background about that original work?

Martijn Cremers:
Yeah, thanks for having me. Active share is a simple measure of active management. It measures how different the holdings of the fund are relative to its benchmark. So, it's very literal. It's the active share. So, it's the share, a portion of the holdings that are different from the passive benchmark that are active.

So, active share simply tells you how different the holdings are, how much stock-picking the manager is doing. Say, if you buy a fund with a high active share, it means that you buy a fund that has very little overlap with a passive benchmark index that you generally can get for very low expenses.

Tim Paulin:
Martijn, in your research, you suggested that there are different thresholds for the types of strategies that we would consider to be active, or those that might be inactive or even closet indexers. Can you expand on that a bit and tell us what the implications are for investors?

Martijn Cremers:
Yes. In general, if you're looking for a fund manager that is a really a fundamental stock picker, you're looking for a high active share. So 60% or below, we identify as not very active, and those funds should also then be very inexpensive. Because if you have a fund with low active share, say below 60%, then those funds have substantially large overlaps with the benchmark. Those overlapping holdings in the benchmark are available at very low cost through some index funds.

So, high active share indicates very different holdings than the benchmark. What high is, also depends on the investment universe. So for example, large cap funds tend to have lower active shares and small or mid-cap funds tend to have higher active shares.

If you think about the top quintile of funds in terms of active share, then the top quintile for large cap funds would be active share of 80% or so, and higher. For mid-cap funds, top quintile would be 90% or so, or higher. For small cap, may be 95% or so, and higher. So, what high active share is, to some extent depends on the investment universe that you're looking at.

Tim Paulin:
So, as investors and investment practitioners, we need to change our bars with respect to what we consider to be truly active?

Martijn Cremers:
Yes, exactly.

Tim Paulin:
Thank you. So Martijn, in your research, you've indicated that there are different thresholds for what we might consider to be truly active. Even thresholds, if we reverse them, that might indicate what funds might actually be closet indexers. I wonder what the implications are for investors, if this threshold for whether a fund is active or not changes by the investment universe.

Martijn Cremers:
Good question. In general, if you're looking for an individual stock picker, you're looking for a manager with a high active share, while this high active share depends on the type of securities that the manager is selecting for the portfolio. If you have a low active share, that means you have a large substantial overlap with the benchmark.

Low active share, I would say is anything of 60% and lower. There's no problem with that, but those funds should also then be very inexpensive. High active share depends on the investment universe. For example, large cap funds tend to have lower active shares than mid and small cap funds.

So, if you think of truly active funds as being in the top quintile, the top 20% in terms of active share within their category, then for large cap funds, that would mean an active share of 80% or so, or higher. For mid cap funds, you are looking at a threshold of about 90%, and for a small cap, you are looking at top quintile being about 95% active share or higher.

Tim Paulin:
One of the things you mentioned was that if funds have active share less than 60%, they should also be inexpensive. Can you expand on that some?

Martijn Cremers:
Yes. So, if you have funds with an active share, let's say in the 60s or below, then those funds have substantial overlap with the benchmark index while the benchmark index holdings are available at very low cost. So by extension - funds that look very much like the benchmark, and they should also be inexpensive because so much of their holdings are the same. So, their outperformance, what you really pay the fees for that can only be driven by the part of the portfolio that is different.

So, if you have similar holdings, you're going to get similar performance. If you want to outperform, if you want to earn your fees back, you need active share. If you have low active share, it's going to be very hard for the manager to do that because so much of the portfolio is the same. That's not going to generate different performance.

Tim Paulin:
Interesting. I think about that concept. Sometimes we talk to advisors and investors to change the lens a bit from, "Is this a cheap active manager?" to, "Is it possibly an expensive passive manager or is it somewhere in between?"

Martijn Cremers:
No, exactly. So a low active share manager is to, in my mind is a manager who only partly actively manages the portfolio. So, I think of a low active share manager as a manager where part of portfolio is really passively managed, and the other part of the portfolio is actively managed. You only want to pay fees for the part that is actively managed.

Mary Mock:
In the next part of their conversation, Tim and Martijn talk about execution. The effectiveness of active share really comes down to the execution, and Martijn discusses some pitfalls that financial professionals can find when using active share concepts.

Tim Paulin:
So Martijn, we found some pitfalls and how advisors and investors are applying active share into their due diligence efforts. Can you share some of the pitfalls you've seen in application of active share?

Martijn Cremers:
Sure. So, I think of active share as a starting point. If you're looking for a manager that does a lot of individual stock-picking, you might look for a manager with high active share. Again, that's just a starting point. Another important thing is that active share does not measure skill. Active share simply measures how different the holdings are. It does not measure the skill with which those holdings that are different are chosen.

Finally, active share is relative to a benchmark. So, if an active share is relative to a particular benchmark for the funds, if that benchmark is not the right benchmark for the funds, then the active share number is not the right active share number either.

Tim Paulin:
Martijn, I'd like to build on the pitfalls you just talked about for a minute. Let's start with benchmark relevance. What we found is when advisors that we work with go to your website, activeshare.info and pull up the active share for a particular fund, sometimes they may get a false sense of confidence based on a high number that they see for a particular strategy. What are some of the issues around benchmark relevance that we need to be aware of?

Martijn Cremers:
So, you want to make sure that the benchmark that is in the prospectus for the fund is the right benchmark for that fund. We find in our research that this is the case for about 75% of funds, but for 25% of funds, we find that there's another benchmark that actually is more appropriate. So, if you go to the website, we showed the active share with respect to two different benchmarks for funds.

One is for the prospectus benchmark, but the other one is for what we call the minimum active share benchmark. If those two are different, if those two benchmarks are economically quite different, then that's just indication for us that the prospectus benchmark may not be the right benchmark for the funds.

In that case, investors should be careful in interpreting the active share with respect to prospectus benchmark. They should also consider the active share with respect to the minimum active share benchmark.

Tim Paulin:
So, one of the ways I would think about an example for a practitioner would be, if they had invested in the fund with the objective of obtaining mid-cap exposure, and that fund has a prospectus benchmark of the Russell Midcap Index. If they find that the best benchmark, the minimum active share benchmark for that strategy was a large cap index, it might suggest two things.

Number one, they're not getting the exposure that they're looking for, and number two, that the false sense of security they got about high active share relative to the mid-cap benchmark might not be justified. Is that accurate way of thinking?

Martijn Cremers:
Yes. No, exactly. What we found in our research is that for those funds where the benchmark in the prospectus is not the best benchmark, that the minimum share benchmark, which we think is a better benchmark is generally more risky. So, what this also suggest is if you simply compare the funds to a prospectus benchmark, which for this group of funds may not be the best benchmark, You're also comparing the fund to a benchmark that is relatively less risky. So, you also get the sense that you may be underestimating the risk in the funds by comparing it to a benchmark that is not the best fit, but that is also less risky than the fund actually is itself.

Tim Paulin:
Martijn, I want to build on one of the pitfalls you mentioned around the concept of skill because naturally, investors aren't simply looking for something that's active, that's different than a benchmark. They also want to know, "Is this a manager that's going to help me achieve my goals?" So, how do you think about the concept of skill related to this concept of active share?

Martijn Cremers:
So active share, it's not a matter of skill, but I still think it's related to skill. A skill ultimately means that the manager can outperform in the long-term. What we found in our research is that managers with low active shares, especially those that are not inexpensive, substantially underperform on average in the long-term. Manager with high active share did not underperform.

I also think that if you have a manager with strong long-term outperformance achieved through a high active share with a strategy, that requires a certain courage of the manager's convictions, that really suggests the manager has skill. So, if skill is outperformance and if active share is related to skill, then a key test for that is the combination of being a high active share manager and having good long-term past performance. The key test for skill is performance persistence in the long-term, and that's what we found in our research.

So, when we look across high active share managers and then from those, we look at those that also have strong long-term past outperformance. Then, we see substantial performance persistence. Those managers that currently have high active share and also have strong past outperformance then those managers on average tend to outperform substantially also in the future. That for us is evidence that active share is related to skill.

Tim Paulin:
So, you talked about past performance, outperformance, performance persistence, those are general ways of doing things when it comes to evaluating skill. What I'm hearing from you is avoidance of any very specific measures to say, "This is how you should absolutely measure skill." Is that an accurate way of thinking about it?

Martijn Cremers:
Yeah. So, investors will all have their own ways of evaluating performance. In practice, I think most investors compare the performance of the funds to the performance of the benchmark, which I actually think is fine as long as you have the right benchmark.

Mary Mock:
Next, Tim and Martijn discussed the three pillars of active management.

Tim Paulin:
Martijn, in 2017 the Financial Analyst Journal published your paper about the three pillars of active management. One of those pillars is skill. The other two are conviction and opportunity. Tell us about how those three things relate to each other.

Martijn Cremers:
So, the framework of the three pillars of active management are skill, conviction, and opportunity. In the 2017 article, I make the case that active managers who can outperform in the long-term really need all three. They need skill, but they also need to apply that skill in a strategy that requires the courage of the manager's convictions. Without that, what prevents too much money flowing into the strategy or what prevents others from doing the same thing, if there are not these economic frictions, barriers to entry, if you like. One way to think about those barriers to entry is a strategy that requires the courage of the manager's convictions.

Third, the manager needs opportunity. I think of internal and external constraints that may limit the opportunity of the manager. External constraints is opportunity in the marketplace, and internal constraints would be restrictions put on the manager internally like tracking error constraints. If the manager has too many constraints, internal and external, and even if the manager has skill and conviction, the manager won't be able to actually execute.

Tim Paulin:
So Martijn, along those lines, we're often asked for an example of a situation where one of those elements may not be present. An example I often give would be: consider a situation where you find that you have a manager with a long record of outperformance, so they feel confident that they’re skilled. They find a high active share. They find a portfolio that evidences conviction. So, they feel like this manager does have the courage of their convictions. Then, either because of external forces or the manager's own decisions we find opportunity might be constrained. You mentioned tracking error and limiting tracking error. If we tell some manager, "We want you to act with a tight tracking error to a benchmark, but we want you to be highly active," that can be very difficult to achieve."

The other element that might constrain opportunity, is size. We see a lot of successful managers with very good performance that grow to enormous asset sizes. Can you talk a little bit about how that kind of constraint on opportunity can impact results?

Martijn Cremers:
Yes. If the fund grows in size a lot, then the active share tends to go down. Our research suggests that those types of funds with very strong past outperformance that was achieved generally through a high active share strategy has to become very large. They perhaps become too large. The active shares go down, and then their past outperformance does not persist.

Tim Paulin:
So Martijn, the three pillars of active management, skill, conviction, and opportunity are pre-conditions to outperformance over time. I wonder if you could dive a bit deeper into the area of conviction?

Martijn Cremers:
Sure. Let me give an example of a strategy that I think requires the courage of one's convictions and that is patience. Most patient capital think of managers who've owned stocks for two years, or three years, or longer. Most patient capital is not very actively managed, and most active managers are not very patient. That's because the combination of being an active manager with a high active share and implementing a patient approach is very difficult, or it's difficult to be patient in an inpatient world.

There's a mismatch for those funds between the holding periods of the manager, say three years, and the period of which performance of those managers is evaluated by the investors, which is generally much, much shorter than that. That mismatch creates risk for the manager, creates a real challenge and therefore it is hard to do.

As a result, I think managers who are able to do it, are able to benefit from opportunity in the markets that require a long holding period and substantially outperform. Because it's hard to do, there's  few managers who actually combine the high active share strategy with the patience approach, and those few managers who are able to do it have substantially outperformed. We documented that in the paper we published a couple of years ago entitled Patient Capital Outperformance.

Tim Paulin:
Excellent. One of the things I think about with respect to active managers is that we often refer to active managers as stock pickers, but essentially, they're company pickers. They're trying to identify a small set of companies that will create outperformance, will create additional capital over longer periods of time and that's often a different way for investors to think about what am I really trying to achieve? Am I investing in a market? Am I investing in exchange? Am I investing in a factor? At the end of the day, no matter what combination you're investing in, you're investing in a set of companies.

What we're trying to find is long-term outperformance, and what people get hung up in sometimes is what happened this past quarter? What's going to happen with the next quarterly report? It takes away from their concept of what really drives long-term outperformance, which is the performance of those fundamentals of those underlying companies.

Martijn Cremers:
Yes, that's true. If you think about a high active fund manager with a patient strategy, I think those managers tend to think like owners. They invest in those companies thinking like owners. So, they place a bet not just on the company, or industry, or the markets in general, but they really place bets on the whole management team. So, they think like owners. They think long-term.

Mary Mock:
To round out their conversation, Tim and Martijn looked at the changing fiduciary environment for financial professionals and how active share fits within that.

Tim Paulin:
Martijn, one of the things we're seeing over the course of the past several years in particular in an evolving fiduciary environment for financial professionals is a big focus on expenses. What's the cost of my investment, or what's the cost of my particular active strategy? You have a more nuanced approach to evaluating cost of active strategies. Tell us about that.

Martijn Cremers:
Yes. I argue that how much you pay for a fund should be related to the active share. So, for a low active share funds, the fees should be low. For a higher active share fund, it's more natural I think that the fees will be higher. A simple way to think about this is to take the ratio of the expenses divided by the active share.

That kind of assumes that you can invest in the benchmark or the index fund for very, very low or no expenses. Then, you're really only paying the expense ratio and the expenses for the active part of the portfolio, the part that is different from the benchmark, the active share of the portfolio.

This ratio of the expenses over the active share is what we call active fee. So, it gives you a sense again, the active fee of how much you're paying for the active parts, if you like, of the portfolio.

Tim Paulin:
Is it fair to suggest that the active fee is somewhat of a hurdle rate because it's the proportion by which the active part of the portfolio has to outperform in order for the entire fund to beat the benchmark?

Martijn Cremers:
Yes, exactly. So, what you see then is that for the low active share funds that are not inexpensive, their active fees are going to be pretty high, and those managers have substantial hurdle rates to outperform. The active fee for high active share managers may actually be lower than the active fee for lower active share managers for that exact reason.

Tim Paulin:
One of the interesting things is, you've done all this research. Advisors and investors are used to going to certain places to evaluate funds, active funds in particular. Where can investors find more information about the three pillars of active management, patience, active fees, et cetera?

Martijn Cremers:
Well, you can go to my website, activeshare.info. The website activeshare.info gives information of U.S. equity funds that are in my sample that I used for my academic studies. So, it gives you the active share with respect to the prospectus benchmark. It gives you the active share with respect to the minimum active share benchmark. It gives you a sense of where the holdings are in terms of what percentage of the holdings is also part of the benchmark. What other part of the holdings are not part of the benchmark. It tells you the holding duration of the assets currently in the funds. It also calculates the active fee. So, it gives you a lot of information that is available for free on active share info, all the things that we talked about today.

Tim Paulin:
Martijn, your most recent paper is essentially a compendium of academic research on active management. What did you find as you evaluated 20 years of active management research?

Martijn Cremers:
Yes. Our most recent publication published in the Financial Analyst Journal very recently is a survey article where we look at over 200 academic papers on active management. So, the informal tagline of the paper is, “We read 200 academic articles so that you don't have to”.

The title of the paper sums it up, “Challenging the Conventional Wisdom on Active Management. So, the conventional wisdom right now, I think, is based on the research that was done in the '80s and the '90s. The conventional wisdom says that it's very, very difficult to find active managers that outperform.

So, we surveyed the last 20 years of academic papers on active management, and we find that this literature gives many examples of studies that suggest the opposite. That's why we think that the actual academic literature of the last 20 years really challenges this notion and makes the case, I think for much more positive assessments of the value of active management.

Tim Paulin:
Again, I'm Tim Paulin. I'm with Touchstone Investments. I'd like to wrap up by thanking Martijn Cremers for being with us here today.

Mary Mock:
Thanks to Tim for guiding our conversation on active management, and especially to Martijn for his insights and research on this topic. Until next time, I'm Mary Mock.

Steve Graziano:
Thank you for listening to Distinctively Active Investing. You can find the resources mentioned in the episode and learn all about Touchstone active managers at www.touchstoneinvestments.com. If you like the show, please share it with someone you know. We appreciate when you subscribe to the show and take the time to leave us a rating and review.

Steve Graziano:
Find our podcasts on Apple Podcasts, Spotify, or your favorite podcast app. I'm Steve Graziano. From all of us at Touchstone Investments, thank you for listening.


Touchstone Investments has partnered with Martijn Cremers to provide consulting services. Touchstone and Professor Cremers are independent of each other.

Past performance is no guarantee of future results. Active Share is not a performance measurement. A high level of Active Share does not assure outperformance of a fund relative to its benchmark index.

The information provided is for general information purposes and is not investment advice. Opinions may change without notice based on economic, market, business, and other conditions. Please consider the investment objectives, risks, charges and expenses of the Fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one at TouchstoneInvestments.com/resources or call Touchstone at 800.638.8194. Please read the prospectus and/or summary prospectus carefully before investing.

Touchstone funds are distributed by Touchstone Securities, Inc., me
mber FINRA SIPC.

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