John Rogers: How To Avoid The Index-Hugging Syndrome by John Rogers, Forbes

H/T Dataroma

Somehow “passive” has become the investing theme of the moment. Tons of money is flowing into index funds and ETFs. I am also hearing about “the death of active management.” I’ve heard about the death of a lot of things in my time–radio, television, pen and paper–and they’re all still here. Meanwhile, plenty of experienced, highly active managers are earning their keep.

For decades many active managers were at odds with the academic community. Most studies have suggested that active managers cannot dependably outperform the market. Vanguard has built a giant business capitalizing on this widely held belief. One professor from the University of Notre Dame, K.J. Martijn Cremers, has come to active mutual fund managers’ defense with his “Active Share” metric.

His 2006 paper, coauthored by Antti Petajisto, was called “How Active Is Your Fund Manager? A New Measure That Predicts Performance.” Active Share quantifies how much an actively managed portfolio differs from a benchmark. A fund with 0% Active Share would be identical to the benchmark, while a fund with a 100% Active Share would have no overlapping exposure. The paper concluded that low Active Share portfolios, on average, were basically doomed to underperform, while high Active Share portfolios (of 80% or more) had a shot at outperforming. In other words: Don’t “hug” the index.

Cremers, now working with Ankur Pareek of Rutgers Business School, has a new paper: “Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently.” Its first sentence clearly lays out the main point: A mong high Active Share portfolios, only those with patient investment strategies–holding stocks at least two years–outperform.

The dense paper, full of mathematical equations, essentially boils down to a few key findings that most serious value investors already know. Don’t be afraid to deviate from the norm, invest in contrarian stocks in which you have high conviction, and be very patient. Here’s how the paper concluded: “Our results thus suggest that Warren Buffett’s investment skill seems generally shared by mutual fund managers in the top Active Share and Fund Duration quintiles.”

Here are three of my highest conviction (Active Share) equity picks. You will note that they aren’t the kind of stocks most index-hugging mutual fund managers would have much interest in.

One-hundred-and-one-year-old Brady of Milwaukee is an identity-solutions company that recently made up 3% of Ariel Fund assets–but just a 0.1 % position in my Russell 2500 Value benchmark. In Cremers’ terms that contributes a 3% Active Share to the portfolio’s overall score. Brady began life as essentially a sign company, made a huge stride in the 1940s with self-adhesive “wire markers” to help electricians and now has more than 50,000 products–from employee IDs to sorbents–that identify things for the sake of safety and efficiency.

It’s not an especially glamorous business, but it’s a necessary one –and Brady is the leader in the field. New CEO J. Michael Nauman is going to concentrate on organic growth, not acquisitions, so I think its forward price/earnings ratio of 14 makes it look even cheaper than it will a few years from now.

See full article here.

John Rogers: How To Avoid The Index-Hugging Syndrome