How should you measure performance?

Every investor has the same goal: maximizing performance while limiting risk.

The question is how to get there. Opinions are divided on the best strategies, and which metrics best help investors evaluate their options.

Active vs. passive

There are two primary investment strategies to choose from: passive and active.

With passive investing you buy a basket of securities that more or less replicates an index, like the TSX. How much of a particular stock or sector you buy isn’t determined by an advisor, portfolio manager or analyst, but rather by how large the company or sector is relative to others on that index.

Active investing, by contrast, puts the process of selecting stocks, bonds and other securities in the hands of portfolio managers. They use a wide range of analytical tools to build portfolios they think will perform better than the broader market.

Company metrics such as return on equity (ROE), return on invested capital (ROIC) and debt-to-cash flow help them assess whether a stock has the potential to outperform. If the market as a whole goes up 2%, these managers aim to squeeze out 4% or 5%—or more.

How does this work?

For an active manager, it’s not the size of a company, but what’s under the hood that matters. Individual firms that are financially sound, or companies operating in sectors where there is strong product demand, will get more weight in a portfolio than companies or sectors with less impressive prospects.

For example, an active manager may look at several research reports and conclude the resource sector as a whole will be facing rough times, while the consumer staples sector appears ready to go on a tear. Based on this conclusion, the manager will give more weight than the index does to consumer staples stocks, and less to resource stocks.

By deviating from an index’s weightings, and providing her assumptions prove correct, the active manager should lose less than the index when markets are down, and gain more when they are up.

Using active share to measure performance

Many industry observers point to studies suggesting a majority of active managers can’t beat the index when fees charged to investors are taken into account. This has led to claims that active managers aren’t worth the cost.

But a new metric, called Active Share, developed by Yale researchers K. J. Martijn Cremers and Antti Petajisto, suggests a problem with these studies.

Active share measures, in percentage terms, how much a portfolio deviates from an index. The metric shows that about a third of U.S. mutual funds claiming to be actively managed actually follow a passive style and overlap their benchmark indices. Further, it found only a quarter of active funds are truly actively managed.

So, the reason many funds labelled as actively managed don’t beat the index is that they are, in fact, too similar to the benchmark. By contrast, funds with a high active share – significant deviation from index weightings – tend to outperform.

Bottom line, many funds don’t beat the index because their managers are what some investment industry observers call closet indexers.