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Morningstar Publishes Research Examining Active Share Data, Finding One in Five European Equity Funds is a Closet Indexer; Proportion of Indexers is Shrinking

Morningstar, Inc. (NASDAQ: MORN), a leading provider of independent investment research, today published a research report, “Active Share in European Equity Funds.” The analysis reveals that 20 percent of the funds examined qualify as closet indexers, which are actively managed funds that largely mimic their benchmark while charging active management fees. However, the proportion of funds in the analysed categories that can be characterized as closet indexers has been falling in recent years. Active share quantifies how much of an equity portfolio's holdings differ from its benchmark. A portfolio with an active share score of 100 percent would have no common holdings with its category’s index while a portfolio with an active share of 0 percent would be identical to its benchmark. The higher the score, the more actively the fund is managed.

Authored by Senior Manager Research Analysts Mathieu Caquineau, Matias Möttölä, and Jeffrey Schumacher, the research report examines how active share has developed over a 10-year period, from 2005 to 2015, for the Morningstar Categories Europe Large-Cap Value Equity, Europe Large-Cap Blend Equity, and Europe Large-Cap Growth Equity, consisting of European large-cap funds investing in European equities, and encompassing 456 offerings. It is a comprehensive report that examines active share in Europe from many perspectives, including historical changes in active share, the relationship between active share and performance and active share and risk, and the role of active share in fund selection. The study is based on proprietary holdings data for European funds collected by Morningstar since the early 2000s.

“Although we identified one in five European equity funds as a closet indexers,  our research shows that the proportion of closet indexers has been shrinking,” Möttölä said. “Average active share levels dropped considerably during the financial crisis of 2008 and 2009 but have been rising at a steady pace since then. In Europe we’ve witnessed increasing scrutiny from regulators in many countries, which could lead to structural change and less closet indexing in the market.”

Möttölä added, “Investors who use active share as a fund selection tool should exercise caution. As active share increases, dispersion in returns and risk levels rises sharply, with both the best- and worst-performing funds found among the more active funds. It is the portfolio managers’ skill in selecting the right deviations from the index that generates outperformance. Among the least active funds, we found that almost all closet indexers underperformed their benchmark. If combined with high fees, such a fund is rarely a good choice.  Investors should compare fees carefully as funds with similar active shares can have fees that differ greatly. We believe active share is best used only in combination with other quantitative and qualitative tools.”

Additional key findings of the research report include:

  • Average active share for European large-cap funds was 70 percent in the three-year period through March 2015, with a median of 72 percent when measured against their appropriate style indices.
  • Although funds in the most active quartile charge 33 basis points more on average than those in the least active quartile, European investors are overpaying for low active share funds when price is measured per unit of active share.
  • Funds with the highest active share have stronger style biases than the average across the sample. For example, the asset-weighted share of small- and mid-cap securities in a fund’s portfolio rose from an average of 8 percent for the least active funds to 30 percent for funds with the highest active share. This complicates the use of active share in fund selection because such style biases may not be desirable from an investor’s point of view.
  • Historically, funds in the highest active share quartile have had better performance, on average, than those in the least active share quartile. In four out of five five-year periods, funds in the highest active share quartile performed better than funds in any other quartile. However, the dispersion of excess returns is highest for funds with the highest active share, making it ill-advised to rely solely on active share as a way to select funds. The difference in excess returns between the most and the least active funds has decreased, falling to 40 basis points for the period from mid-2010 to mid-2015.
  • Closet indexers, or funds with a three-year average active share below 60 percent, represent 20 percent of the 456 funds Morningstar evaluated. The peak in closet indexing clearly coincides with the aftermath of the global of financial crisis, with the proportion of closet indexers nearing 40 percent in 2008. The majority of recent inflows in European equities have landed in the most active funds.