Monday, August 21, 2006

Active or Passive?

From the Wall Street Journal:

Professors Shine a Light
Into 'Closet Indexes'
Measurement May Help Investors
See How Much of Their Holdings
Are Actively Managed -- And Not
By TOM LAURICELLA
August 18, 2006; Page C1
Are your mutual-fund managers earning their keep?
A complaint lodged against many managers of funds that invest in stocks is that they collect big fees for doing little more than basing their stock picks on the market index -- say, the Standard & Poor's 500-stock index -- against which their fund's performance is measured. There's even a term for this behavior: closet indexing.
....

You can read the whole article here (subscription required).

The upshot is that these two Yale professors have devised this dead simple way to tell how active your fund is -- and whether the managers are earning their fees. They just take the holdings (as disclosed to the SEC for US funds) and subtract from the percentage held in each stock the percentage that stock is of the index. If the fund holds two stocks (A & B) equally weighted and A constitutes 4% of the benchmark index and B constitutes 3% of the index, the active percentage would be calculated as (50%-4%)+(50%-3%)=93%. It would be interesting to see if this measure has any correlation with return or idiosyncratic risk of the portfolio. If anyone knows of any academic papers on this measure, let me know in the comments. A quick search of SSRN turned up nothing.

UPDATE: Here's a link to the original paper on the Yale site.

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