“Portfolio Drag” as the True Cause of Underperformance

Professor C. Thomas Howard of University of Denver (also CEO of AthenaInvest) reports in Advisor Perspectives that his research shows underperformance among actively managed equity funds is caused primarily by “portfolio drag,” rather than stock-picking mistakes or fees. He says that “nearly 90% of active equity fund managers are superior stock pickers” and “the funds most likely to outperform charge higher fees.” His term “portfolio drag” refers to three “structural decisions made by fund companies: asset bloat, closet indexing, and over-diversification.” Howard has developed a “Portfolio Drag index (PDI)” to measure and rank these inefficiencies, and reports his methodology and data in the article.


“Asset bloat” refers to Howard’s finding that “fund performance declines with fund size as measured by [assets under management].” Closet indexing, he asserts, is a “painfully obvious” problem: “it is truly strange that the industry has evolved to the point where funds are expected to closely track the benchmark while, at the same time, beat their benchmark!” He attributes this situation to loss aversion and short-term focus. He also maintains that keeping a fund within a specific “style box” is a drag on performance: “this study shows that funds with the greatest amount of style drift outperform those with the least drift by 3.00%” and “a fund cannot outperform, on average, if it does not style drift.” Howard discusses his diversification findings in terms of conviction, commenting: “individual stock alphas decline as a stock’s relative portfolio weight rank declines.” He found that “high conviction stocks can be identified by means of holdings and, in turn, these high conviction stocks subsequently outperform.” Further, he reports that increases in a fund’s top 20 stocks increase alpha, while increasing the weighting of lower weighted stocks has a negative effect on alpha.


Overall, Howard concludes that his “PDI is a guide for making better decisions” because it captures the factors that actually reduce fund performance. The article provides a detailed enough description of his findings and metrics that investors may be able to take his findings into account.