EdgePoint Canadian Portfolio and the three pillars of active management
11/21/2017 10:29:04 AM
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Informative and authoritative articles on the world of investment funds from Fundata’s Investment Analytics and Research team.



By John Krisko  | Thursday, November 02, 2017


 

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The “Three Pillars of Active Management” may sound like the title of a trendy self-help book. While it is self-help of a kind, it won’t help you lose weight or deal with cholesterol. In fact, it’s a relatively new financial theory that serves as the theoretical foundation for an analysis of the actively managed portfolio of an investment fund. And it can be a useful additional tool for investors, analysts, and portfolio managers to add to their arsenal of fund metrics when screening for investments for portfolios.

The idea of the three pillars was recently proposed by Dr. Martijn Cremers, Professor of Finance at the University of Notre Dame, in his article “Active Share and the Three Pillars of Active Management: Skill, Conviction, and Opportunity,” in Financial Analysts Journal. As he explains, “the three pillars of skill, conviction, and opportunity are an application of the philosophical idea that practical wisdom involves the full triad of right knowledge, good judgment, and effective application…”.* We nod our heads in agreement. It just makes sense…but now what?

The doctor is in

Well, lucky for us, the good doctor is just getting started, and he has the prescription we need to translate those lofty ideals of right knowledge and good judgment into measurable, actionable results. Dr. Cremers examines funds in the context of each of the pillars independently in order to make an overall assessment of actively managed funds1. We will follow along by using these techniques to analyze a Canadian equity fund we are considering for investment2. The best of these is the EdgePoint Canadian Portfolio, well on track to win a third consecutive FundGrade A+® Award.

Opportunity knocks

The first pillar is Opportunity, defined as the degree to which an investment environment is conducive of the ability to earn active returns, or alpha. Our treatment differs from Dr. Cremers, who examined U.S. equity funds in general, where it found that small-cap stocks generally provide a greater opportunity to earn alpha compared with large caps. In contrast, we begin with a specific set of funds, which are all similarly constrained by the thresholds of the CIFSC Canadian Equity category and thus have the same level of opportunity3.

A test of faith

The second pillar is Conviction – the faith that the manager has in their stock picks. This is important because the ability to pick stocks is meaningless without the confidence to hold them long enough to generate returns. The measure Dr. Cremers uses for Conviction is Fund Duration, that is, the time-weighted age of each stock position a fund currently holds, weighted by total assets to produce the average holding duration of the fund4. The period used to calculate Fund Duration is 18 quarters through 06/30/2017. As a proxy for a Canadian Equity category average, results for the funds with the next highest YTD return (Top) and the lowest YTD FundGrade GPA and return (Bottom) are also presented. An outline of how to find a fund’s holding duration is presented below.

What we find is that EdgePoint Canadian Portfolio has a Fund Duration of 2.2 years for positions it currently holds. In other words, over the past 4½ years, a stock has been held for an average 2.2 years. Compared with the Fund Duration of the Top fund at 3.3 years and the Bottom fund at 2.4 years, it seems that the duration of EdgePoint Canadian Portfolio is likely below the category average. Fund Duration is primarily a measure of stability and conviction, but evaluated in isolation, it does not tell us much. No benefit is gained from a long-held position that does not appreciate. This leads to the third and final pillar: Skill.

Earn your keep

The pillar that Dr. Cremer calls Skill examines the successful stock-picking ability of the manager. Essentially, we will answer the following questions: How actively is the fund being managed? What is the effective fee for that management? Is the fee justified by the fund’s performance? The answer to the last question will determine if the manager is a skillful stock picker.

To start, a passive benchmark against which to compare our actively managed funds is needed. For funds in the Canadian Equity category, the most appropriate benchmark is the S&P/TSX Composite Index, represented by iShares Core S&P/TSX Capped Composite Index ETF5. The following infographic illustrates the calculation of the measures described below.

Active Share is the percentage of the portfolio that does not overlap with the benchmark. Using the new method of calculation introduced by Dr. Cremers, it will provide the answer to our first question. The measure includes the total percentage of stocks not held by the benchmark plus tactical over or underweighting in overlapping positions. The Active Share will tell us to what degree each fund is being actively managed. Cremers and Curtis (2016)** define funds with an Active Share of less than 60% as “closet index funds” – that is, funds that represent themselves as actively managed but actually invest much like an index fund. The result is in effect a high-fee index fund that is likely to underperform.

EdgePoint Canadian Portfolio had an Active Share of 87% as of June 30. This is quite high and points to a significant amount of active management, which might be expected for a fund that consistently outperforms its peers. In contrast, the Active Share of the Bottom fund is 50% and places it well within the threshold for closet indexing, perhaps indicating one reason why it has underperformed. Surprisingly, the Top fund has an Active Share of 66%. While it is above the 60% threshold for closet indexing, it is still lower than what might be expected for a fund that has performed so well. Although Active Share provides insight into the degree of active management, it is not itself a measure of skill; it only evaluates a difference in holdings from the benchmark and not the performance of those holdings.

Continuing with the second question, we will determine how much each fund is charging for active management. To determine this, we will calculate the Active Fee measure used by Dr. Cremers.

The reasoning behind the Active Fee is this: If an investor wished to own a portfolio of stocks in the same proportion as the benchmark, they would simply purchase that portfolio and pay the low index management expense ratio (MER). Therefore, the MER charged by an actively managed fund is appropriately evaluated only against active stock selections, less the fee attributable to overlapping index positions. The Active Fee effectively restates the MER in terms of the current actively managed percentage of the portfolio (Active Share). It does this by backing out the portion that overlaps with the benchmark at the equivalent rate charged by the benchmark and attributing the remainder to the Active Share. The Active Fee values are summarized in the table below6.

EdgePoint Canadian Portfolio has by far the lowest Active Fee of the three funds, at 2.47%, which indicates the effective cost of active management. In both the Top and Bottom funds, a combination of low Active Share and a high MER produces an Active Fee that is almost double the EdgePoint fund. With the overall cost in hand, we can now answer the final question regarding the skill of the manager.

The steps outlined by Dr. Cremers begin by calculating the difference between the Active Fee and the benchmark MER as the Hurdle Rate for active holdings – that is, the return that the active positions must earn above the benchmark in order to justify the additional cost of active management. For EdgePoint, the Hurdle Rate is 2.42%.

Next, we calculate the benchmark-adjusted net return of the fund, which is the fund’s return less the return of the benchmark. This leaves us with a reliable approximation of the fund’s performance in excess of the market. Using the same 18-quarter measurement period and looking at monthly returns results in an annualized benchmark-adjusted net return for Edgepoint Canadian Portfolio of 3.51%.

This is the final piece and allows us to answer the question of skill. If the fund delivers performance in excess of the fee it charges for active management, we may say that the manager is truly skillful. Indeed, that is the case with the EdgePoint fund, as the 3.51% excess return exceeds by a significant margin the Hurdle Rate of 2.42%.

Pillars of success

The EdgePoint Canadian Portfolio is a multi-year (2015-16) FundGrade A+ Award-winning Canadian Equity fund, which clearly demonstrates that the ability to identify and take advantage of opportunities can create value well above the cost of management. It is an excellent example of active management that is “worth it” and demonstrates why a place exists for both passively and actively managed funds in investor portfolios. Furthermore, it illustrates the power of tools, such as the three pillars of active management developed by Dr. Cremers, to help investors make informed choices about the investment products available to them.

Notes

1. The study makes use of additional advanced and computationally intensive methods to produce statistically robust averages for comparison (for example, weighted-average holding durations for all funds in a category) and performance analysis (for example, using the index-based seven-factor model to adjust returns) that were not feasible to reproduce for this article. A review of the original material, which explores them extensively, is highly recommended.

2. Canadian Equity was selected because it very relevant to Canadian investors, data availability is high, and a single domicile category simplified the analysis.

3. The individual mandates and strategies of the managers are self-imposed constraints, unrelated to investing in the Canadian Equity asset class in general.

4. The duration of each position is calculated differently from Cremers (2017), which measures the change in ownership based on the percentage held of all outstanding shares. In this article, change in ownership is measured against the maximum number of shares held over the measurement period, effectively assuming that the fund held 100% of all shares outstanding at some point.

5. “Capped” means that individual positions are limited to a maximum of 10% of the fund; however, this was not a factor throughout the measurement period.

6. The MERs of the Top and Bottom are given as approximations.

References

* Cremers, Martijn. 2017. “Active Share and the Three Pillars of Active Management: Skill, Conviction, and Opportunity.” Financial Analysts Journal, Vol. 73, No. 2 (March/April): 61-79.

** Cremers, Martijn, and Quinn Curtis. 2015. “Do Mutual Fund Investors Get What They Pay For? The Legal Consequences of Closet Index Funds.” Retrieved from SSRN: https://ssrn.com/abstract=2695133.

John Krisko, CFA, is Manager, Analytics & Data, at Fundata Canada Inc., a leading source for investment fund information.

Notes and Disclaimers

© 2017 by Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.

Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Investment funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.

   
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