Active Mutual Funds Starting to Become More Activist

Mutual Funds

Actively managed mutual funds, where fund managers pick the stocks in the fund, may be in decline, but many fund managers are looking to do more with their voting rights.

One of the perks of stock ownership is being able to decide matters related to the company’s operations, by way of voting your shares. Common shares convey this right, stemming from fractional ownership in a company, and mutual funds can own a pretty meaningful fraction of a company they invest in.

While there are a lot of funds out there that own stock in companies, and we might think that the relatively small piece that a mutual fund may own may not have that much influence on a company, when it comes to shareholders, those who bang the drum still get heard. Shares of public companies tend to be owned by pretty divergent groups, and it doesn’t take all that much of a percentage of them speaking at the same time to get companies to at least listen.

Warren Buffet is a good example of someone who uses his ownership in a company to effect change, but Buffet mostly picks companies that already fit his investing preferences and therefore doesn’t need to flex his muscles so much. If Buffet owns a big stake in your company though, you can count on his making his voice heard when he deems it necessary, and he’s also capable of making some pretty big things happen with a company, like the split up of Kraft Foods and their merger with Heinz.

Carl Icahn is a great example of the more aggressive side of activist investing, and even the biggest companies can be manipulated this way if you have a big enough stake. Icahn once loaded up on Apple stock, got them to buy back 1.1 billion shares, and sold for a very nice profit while the price was run up from this mega sized buyback.

The approach of mutual fund managers is more like Buffet than Icahn, and aren’t just looking for the Icahn style pump and dump deals, but are interested more in the longer-term health of the company. This doesn’t mean that the focus is necessarily on the long-term here, but along the way, there may be situations that taking a certain approach may favor one type of shareholder over another, and fund managers are wanting to have their say more in these decisions.

Successful Fund Management is a Pretty Challenging Task

Running an actively managed mutual fund is more difficult than it appears, and a big reason is that you can’t just go with hotter stocks, the ones with higher alphas. Alpha is a measure of the volatility of a stock relative to the market, and those that move more than the market does, such as technology stocks, also tend to go down as well.

This wouldn’t be as much of an issue if not for the fact that mutual funds are pretty defenseless against bear markets, where it may be wise to cut back on your stock exposure or even get out of stocks completely. They can’t, since their charter is to be in stocks, as opposed to hedge funds for instance who can do pretty much anything they want and even short stocks during bear markets if they wish, and they often do wish.

If you don’t balance out the higher alpha stocks with lower ones, you expose the fund to more downside risk than people are comfortable with. When you underperform the market during bull markets, which the majority of stocks do, that’s one thing, but underperforming during bear markets is going to be met with even less favor.

One of the things that fund managers do that they could probably afford to do a lot less of is with diversification. While it’s not a bad idea for general stock funds to not have all of their money in a single sector, due to sector risk, this doesn’t mean that you need a lot of diversity within each sector, nor diversify in so many.

Most of the risk from stocks comes from market risk anyway, and mutual funds cannot hedge against this at all, because that would require moving money away from the long side of stocks in order to hedge. Switching away from higher to lower alpha stocks when the trend moves negative can help, but involves a lot of slippage on both the sell and buy side as funds need to move a lot of stock, which can affect the market quite a bit if not done patiently.

Individual investors at least have the potential outperform funds if they are up to the task, due to not being under the disadvantages that funds possess, but this does require some skill and commitment, and few investors are willing to put the time in to learn this even adequately. People go with funds because they don’t see anywhere else to go in the actively managed arena at least.

They could just buy an index though by way of ETFs, which requires no management at all, and more and more investors are doing that. Index mutual funds have also taken over a lot more, and the largest funds in the world are all index funds.

Trying to Catch Up to the Passively Managed Funds

Actively managed funds haven’t gone out of style quite yet though, and still maintain a lead over index funds, even though only 1 in 4 active funds beat the market. Index funds play the market, and match it less their management fees, which are significantly lower than what active funds need to charge due to their higher operating expenses.

1 in 4 do beat index funds though, so we might think that this is just a matter of people going with them, but the problem is that it’s not just the same 1 in 4 that do this every year. Some do perform better than others, but this is based upon their past results, and the advantages may or may not be retained.

Active fund managers are starting to fight back more by looking to be more active in the companies that their fund owns stock in, although this does not necessarily mean that they will be able to drive better results from this more active participation.

It used to be not long ago that a fund would simply sell their positions in stocks that they came not to like as much, but now they are trying the approach of stepping up and making their voices heard to the company first.

We might wonder what useful advice these fund managers would be able to contribute to companies, given that their expertise isn’t in corporate management and leadership, but this is more about the overall direction in policies where there may be options available that would be more friendly to the fund’s shareholders than alternatives.

An example of this would be with Wellington Management’s stepping in to help put the brakes on Bristol Myers-Squibb’s takeover bid of Calgene. Wellington manages a trillion dollars’ in assets and has up until now taken the traditional role of passivity, and seeing them finally stepping up and intervene this way is seen as a turning point in the industry.

Other firms use this tool more aggressively, buying up enough of a laggard to become shareholders of note under SEC rules, and then start making suggestions. This can certainly cross the line well into corporate management territory, but in some cases, this outside advice may actually be helpful, although not necessarily in the long-term.

Most of the time, with this particular strategy, the goal here is to raise the price of the stock up in the fairly short term, over a year or two. Whether or not these decisions are in the best interest of companies over the longer-term may not matter to these activist funds, but they do have a stake, and are now not afraid to try to leverage it.

Most mutual fund managers do not prefer to be seen as being an activist in this way and make clear that their interests still lie in the long-term. They have come to prefer the term “engagement,” but whatever the term, they are starting to become more engaged overall.

Some are of course engaged more than others, and if their focus is indeed on the long-term, this additional feedback may be actually beneficial. Whether or not this sort of thing will benefit the stocks involved all that much remains to be seen, but with active fund managers in a role that seems to be on the way out to some degree at least, they can’t be blamed too much for at least trying to help the unitholders of their funds and better their performance.

Ken Stephens

Chief Editor, MarketReview.com