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.
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
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
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
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.
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
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
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
6. The MERs of the Top and Bottom are given as approximations.
* 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
John Krisko, CFA, is Manager, Analytics & Data, at
Fundata Canada Inc., a leading source for investment fund information.
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