With active managers coming under increasing pressure to differentiate themselves from the passive fund industry, the need to up their game and become more active has become ever-more important, according to Kepler Trust Intelligence analyst William Sobczak.
After more than 10 years of a bull market, investors who backed low-cost index-tracking funds at the start of this period have been well rewarded and the benign post-financial crisis conditions have helped fuel huge flows into the passive sector.
The most recent data available from the Investment Association revealed that the passive fund industry now represents 16.3 per cent of the total £1.2trn funds under management, or £200.5bn, up from £181.9bn at the start of the year.
Source: Investment Association
“Yet threats often give rise to opportunities,” said Sobczak. “We believe that complacency is always the real enemy, and so competition from passive funds can be seen as a positive development in the industry.”
The analyst said research by academics Martijn Cremers and Antti Petajisto shows that active stockpickers beat benchmarks on average by about 1.26 per cent per year after fees, while so-called ‘closet trackers’ underperformed benchmarks after fees.
As such, there has been a drive for managers in the investment trust space to prove how active they are or risk being squeezed out as closet trackers in favour of cheaper passive alternatives.
One of the more common ways of measuring how truly active a fund is is through ‘active share’ – a tool identified by Cremers and Petajisto that represents the degree to which positions in a portfolio differentiate from the benchmark constituents.
Expressed as a percentage ranging from 0 to 100 per cent – with a rating of 100 per cent suggesting no common holdings with the benchmark – the academics argue that funds with an active share of more than 80 per cent are best placed to outperform over the long term.
However, the measure is far from perfect, said the analyst, particularly when it is used alone as a measure of active management.
“For example, the measure can be impacted by the number of stocks making up a benchmark,” he explained. “Consequently, a single-country equity fund would be expected to have a lower active share than a global equity fund.”
A further problem in relying on active share alone is that the measure can be ‘gamed’. 
“For example, consider an index with a weighting to sector ‘A’ of 20 per cent, made up of four companies each worth 5 per cent of the index,” Sobczak said.
“A manager could put 20 per cent of his or her fund in ‘stock 1’ and thereby add 15 per cent to the active share. If, however, the beta of ‘stock 1’ to the sector is 1, then the 20 per cent weighting in the fund will behave very similarly to the 20 per cent weighting in the index.
“The fund would therefore appear to be highly active, while having less chance of behaving differently from the index than it might first appear.”
While this is an extreme example and could occur by accident, it is possible that managers could be incentivised “to exaggerate how active they are to attract investors and justify their fees, at the same time minimising their active risk to avoid losing their jobs”, said the analyst.
“One of the great benefits of the rise of passives is that behaving like the index is unlikely to be enough to keep an active manager’s job, so this incentive is diminishing,” he said.
It is also difficult to find the data as many funds do not report it on their factsheets.
As such, Kepler analysts prefer other measures that can be used to judge how active an investment trust manager is.
One such measure is tracking error, which indicates the volatility of the difference in returns between a fund and its benchmark. It is derived from actual returns and can signal how a fund has behaved relative to an index.
However, it too is not infallible on its own, with the Kepler analyst noting that it is a backward-looking measure, unlike active share which is more forward-looking.
Another measure that can be used to see how active a manager is is portfolio concentration.
This can be measured in two ways, said Sobcaz: through the number of holdings and the percentage of assets represented by the top holdings.
“In our view, concentration can be seen as a good measure of the confidence a manager has in his convictions,” he said. “Investment trusts, with their closed-ended structure, are in a unique situation which allows a manager a huge degree of latitude in running a concentrated portfolio.”
The analyst said within the equity investment trust universe, the average number of holdings has steadily reduced over the past five years, with the average trust now made up of 75 holdings, compared with 91 in 2013.
“This matches with anecdotal evidence that we pick up when meeting managers of an increasing desire – led by boards or managers – for a more concentrated approach,” he said.
“Along with the absolute number of holdings, we are seeing a dramatic increase in the percentage of net assets in the top-10 holdings.
“The average trust now has over 40 per cent of its net assets in its top-10 holdings, increasing by nearly 6 per cent from 34 per cent in the prior year.”
Finally, Sobczak said the analysts also look at tactical positioning for investment trusts to see how a manager shifts the portfolio over the short-to-medium term.
This involves looking at gearing within an investment trust and the movement between cyclical and defensive companies.
“In a way this is the opposite of how we often think about some of the most ‘active managers’ like Nick Train or Terry Smith, who have very long holding periods and low turnover,” he said.
“However, often the trusts that are hit the hardest are those that are over-geared during a correction, or those that find themselves overexposed to cyclical companies in a recession, and one possible element of fund management skill could be avoiding such blow-ups.”
Last year provided the “perfect scenario” as trust managers sought to navigate corrections and strong rallies.
Performance of MSCI World in 2018
Source: FE Analytics
“Needless to say, the greater the gearing the more risk and the likely under- or outperformance of a trust relative to peers and the benchmark,” said the analyst, noting that managers did reduce gearing during the second half of the year.
Movement between cyclical and defensive sectors was likely to identify managers with strong convictions on those sectors rather than the most successful and the ability to add alpha relative to the benchmark.
“Of course, as with gearing, we have not analysed whether these moves have been on aggregate net positive and alpha generating, as our focus is on highlighting the most active managers, not the most successful,” he concluded.