On April 5, 2018, the New York Office of the Attorney General (NYAG) announced that it had completed an investigation into 14 large fund families, including some of the largest asset management firms in the world. The NYAG’s list included BlackRock, Goldman Sachs Asset Management, JP Morgan & Chase, Oppenheimer, The Vanguard Group, and others. According to the NYAG’s report, it was investigating the relationship between mutual fund fees and disclosure, specifically, the disclosure of the Active Share metric to retail investors. The NYAG concluded that:
- actively managed equity funds have higher average fees than passive funds,
- there was not a clear correlation between the higher fees and higher levels of active management,
- the Active Share metric varied widely across the sample group of 2,344 U.S. equity funds, and
- retail investors did not have access to Active Share information.
This article briefly discusses each of these points and highlights other essential aspects of the NYAG’s report.
The first notable aspect is that the report, and presumably, the investigation were political. The NYAG made it clear in the second paragraph of its executive summary that the investigation was in response to “[t]he Trump administration and Congress [taking] steps to roll back federal investor protections [and] federal courts [reaching] inconsistent decisions about the validity of those federal protections….” In other words, the NYAG disagreed with the current administration and Congress’ attempt to reduce regulation of the fund industry and various federal courts’ decisions to vacate all or part of the Department of Labor’s fiduciary rule. The NYAG also noted the failure of the Securities and Exchange Commission (SEC) to adopt rules to “address these issues.” With this political context in mind, let’s review each of the NYAG’s key findings.
1. Actively managed equity funds have higher average fees than passive equity funds. It’s well-known in the asset management industry that active management creates more costs relative to passive management. Active managers need to hire portfolio managers, traders, compliance officers, and other support personnel to implement their active investment strategies. Currently, artificial intelligence and advanced robotics in the industry cannot replace all the activities performed by these people. Therefore, active managers tend to have higher labor costs, which translates into higher fees.
In its report, the NYAG provides a scatter plot graph to compare the average Active Share and the average expense ratio of the sample population. The chart shows that the sample population is concentrated in a region where the average expense ratio is 0.50% to 1.50%, with an asset-weighted average expense ratio of 0.75%. Indeed, these ratios are higher than the average expense ratio of passively managed funds, which the NYAG states have an asset-weighted average expense ratio of 0.17%. But given their cost structure, it’s reasonable to conclude that active managers will have higher expense ratios. With the rise of passively managed funds, particularly exchange-traded funds (ETFs), investors and their financial intermediaries clearly understand that passive is cheaper than active, which the NYAG acknowledges in its report. But this leads to the NYAG’s next point:
2. There was not a clear correlation between the higher fees and higher levels of active management. Here is the crux of the NYAG’s argument. If we assume that investors know that passive strategies are cheaper than active strategies and that most investors still want some investment in an active strategy, then the issue is whether investors are getting what they pay for (i.e., active management from active managers). According to the NYAG, active managers may not be delivering on their promise. The NYAG uses Active Share as the metric for determining whether investors are receiving the product that they paid for: an actively managed strategy.
Active Share is a concept developed by K.J. Martijn Cremers, Professor of Finance at the Mendoza College of Business at the University of Notre Dame. Professor Cremers has published extensively on Active Share, especially in the past few years. (You can find some of his publications here.) According to the ActiveShare.info website, which is managed by Professor Cremers and Touchstone Investments, “Active Share is the percentage of fund holdings that is different from the benchmark holdings” (i.e., the difference between the active strategy and its benchmark passive strategy).
The NYAG concludes that “there may be a limited relationship between fees and Active Share,” but its statistical analysis is weak. First, the sample population is too narrow to make an overarching conclusion about the mutual fund industry. While a few thousand funds may be considered a large population sample, the sample population’s focus on only one asset class, U.S. equity funds, is narrow. Additionally, the NYAG does not use the same data set for its analysis of expense ratios and its analysis of Active Share. For the expense ratio analysis, the sample set included 2,554 funds, but the Active Share analysis included only 2,344 funds. Also, according to the NYAG’s graphical illustration, nearly all of the sample population has an Active Share score of 50% or higher, which suggests that most of each fund’s portfolio is not correlated to the fund’s benchmark. The NYAG asserts that there “may” be a limited relationship between fees and Active Share, but its graphs suggest that there is a correlation between active and fees.
Further, neither the SEC nor the federal courts have ruled that Active Share is a critical factor when a board evaluates a fund’s fees and its related performance. Under the Second Circuit’s Gartenberg factors, which the U.S. Supreme Court affirmed in Jones v. Harris Associates, Active Share is not a relevant factor that a board needs to consider when evaluating whether an investment adviser’s management fee is reasonable, which is important because the management fee is the most significant part of a fund’s expense ratio. The Gartenberg factors include: (1) the nature, extent, and quality of the services to be provided by the investment adviser; (2) the investment performance of the fund and the investment adviser; (3) the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates; (4) the extent to which economies of scale would be achieved as the fund grows; (5) the extent to which economies of scale would be realized as the fund grows; and (6) whether fee levels reflect these economies of scale for the benefit of fund investors. Although one could argue that the concept of Active Share may be a component of factors 1 or 2, it indeed would not be a dominant component of either factor. Therefore, the NYAG’s focus on Active Share attempts to emphasize an element that is not determinative of an investor’s selection of a mutual fund for investment or a board’s oversight of the fund’s investment adviser and its fees.
3. The Active Share metric varied widely across the sample group. The NYAG’s report did not discuss this conclusion in detail. Instead, this conclusion is mostly embedded in the Active Share versus fees analysis. But as noted earlier, most of the sample population had Active Share above 50% relative to the fund’s benchmark. Without more data from the NYAG’s analysis, it’s difficult to determine how widely Active Share varied across the sample group. A regression analysis of the NYAG’s data would have provided more useful information, including what factors had the most significant impact on a fund’s Active Share; a better analysis would have looked at a variety of factors, as opposed to only a fund’s expense ratio. Without such a review, it’s hard to substantiate this conclusion.
4. Retail investors did not have access to Active Share information. As noted in its report, the NYAG determined that “investors do not all have the same access to Active Share information.” The NYAG notes that while all the firms that participated in the settlement provided Active Share information to institutional investors, only four firms readily provided similar information to retail investors, and most did so through the fund’s website or in its fact sheets. The NYAG notes that retail investors could get access to Active Share information through a financial intermediary that knows about such details, but the report fails to note that most investors buy mutual fund shares through financial intermediaries, and the concept of Active Share is now well-known by these financial intermediaries.
More importantly, the NYAG fails to note that all investors have access to activeshare.info, a website sponsored by Professor Cremers and Touchstone Investments. The site allows any investor to enter a fund’s name or ticker to get information on the fund’s minimum Active Share to the Russell 2000® benchmark and the fund’s self-declared benchmark. The website also provides the fund’s equity allocation for the past four quarters, the Active Share by style and overtime, its expense ratio, and its “active fee.” The most significant drawback to the website is the frequency of updates, which only occur annually, but an investor can subscribe to the site for free, which allows them to receive notification of the data updates.
After presenting the data and analysis to support its conclusions, the NYAG then launches into a political assault on the “recent developments in federal standards” of investor protection. The NYAG discusses the collapse of the Department of Labor’s fiduciary rule as a result of actions taken by the Trump administration, the steps that were made by Congress to drop the rule, and the SEC’s delay in proposing its own fiduciary rule for broker-dealers. (Interestingly, less than two weeks after the NYAG issued its report, the SEC finally introduced its own rule for stricter broker standards, which I discussed in an earlier blog post.) The NYAG’s approach to strengthening investor disclosure politicizes the NYAG’s report and dampens its professed intent to protect retail investors. In other words, the NYAG’s attempt to raise awareness of Active Share is commendable, and perhaps the Active Share metric will one day be used by all retail investors as a relevant factor, among many, when selecting a mutual fund for investment. But the NYAG’s approach to pursuing this goal raises one question: was the purpose of the report to make investors better-informed shareholders, or was it to make a political statement?