In financial literature, there are numerous citations of studies showing that the average mutual fund manager underperforms his or her benchmark index after fees. However, research presented in 2006 by Martijn Cremers and Antti Petajisto of the Yale School of Management introduced Active Share, a new method of determining the extent of active management being employed by mutual fund managers and a tool for finding those that do outperform. (For more insight, read Words From The Wise On Active Management.)
Active Share is a measure of the percentage of stock holdings in a manager\'s portfolio that differ from the benchmark index. The researchers conclude that managers with high Active Share outperform their benchmark indexes and that Active Share significantly predicts fund performance.
Examining 2,650 funds from 1980 to 2003, Cremers and Petajisto found that the highest ranking active funds, those with an Active Share of 80% or higher, beat their benchmark indexes by 2-2.71% before fees and by 1.49-1.59% after fees.
Active Share is also useful in identifying "closet indexers", or managers who claim to be active but whose portfolios are very similar to the benchmark portfolio. Identifying closet indexers is extremely important because active management fees can be a significant hurdle to outperforming the index for anyone holding a portfolio similar to its benchmark. (To learn more, check out Benchmark Your Returns With Indexes.)
The Yale study also found that funds tended toward low Active Share. The study states that the percentage of assets under management with Active Share of less than 60% increased, from 1.5% in 1980 to 40.7% in 2003. Correspondingly, the percentage of fund assets with Active Share greater than 80% went down, from 58% in 1980 to 28% in 2003.
This change is not all explained by the growth in index funds. In 1980, there were very few non-index funds with Active Share of less than 60%. In 2003, funds with Active Share below 60% had risen to 20% of funds and 30% of assets under management. The authors also found that Active Share and excess performance is higher among funds with fewer assets under management.
The traditional measurement of the extent of active management employed by a mutual fund relies on methods that compare a fund\'s historical returns to those of its benchmark index. One such method, tracking error volatility, measures the standard deviation of the difference in a manager\'s returns versus the index returns.
High tracking error volatility indicates a high degree of active management. The logic behind the measurement is that the makeup of the individual stocks in the portfolio will be reflected in the pattern of the returns. If the returns of the portfolio deviate from the index returns significantly through time, the makeup of the portfolio must be significantly different from the index.
While tracking error volatility makes sense and is easy to calculate, it only infers what the manager is doing in the portfolio and does not actually look at the underlying holdings.
In contrast, Active Share is found by analyzing the actual holdings of a manager\'s portfolio and comparing those holdings to its benchmark index. By measuring active management in this way, investors can get a clearer understanding of what exactly a manager is doing to drive performance, rather than drawing conclusions from observed returns.
Active Share is calculated by taking the sum of the absolute value of the differences of the weight of each holding in the manager\'s portfolio versus the weight of each holding in the benchmark index and dividing by two.
As a simple example, suppose that a benchmark index includes only one stock. If a manager decides that he or she likes the stock, but wants to invest only half the portfolio in that stock and half in another stock, then the Active Share would be 50%.
The Active Share number in this example is essentially saying that 50% of the manager\'s portfolio differs from the benchmark index.
Although the data revealed in the Active Share study is intriguing, investors should be cautious when trying to apply the findings. The benchmark-beating results of high Active Share managers mentioned previously are an average of that group. It would be wrong for investors to interpret the results in a manner that leads them to conclude that all managers with high Active Share portfolios will beat their benchmarks. The data only indicates that the average performance of this group of managers has been better than the average performance of managers with low Active Share.
Of course, it is likely that a number of managers with high Active Share portfolios underperformed their benchmarks while others outperformed. Investors who only rely on Active Share as an indicator of market-beating performance could still pick a manager that underperforms the benchmark.
While the information related to Active Share may be enticing, the results are of little use unless they are persistent. Cremers and Petajisto find significant persistence in high Active Share managers\' abilities to continue to deliver excess returns relative to a benchmark index.
Based on the results of the study, Active Share appears to be a useful tool in determining the likelihood that a manager will attain benchmarking-beating results. Unfortunately, finding managers with high Active Share is not easy. The process of comparing numerous mutual fund managers\' portfolios to their benchmark indexes is time consuming and labor intensive. Providers of mutual fund statistics may provide this measure in the future. Until then, investors must analyze mutual holdings obtained from the funds themselves, database providers or Securities And Exchange Commission (SEC) filings. (For another method of comparing portfolio managers, see Is Your Portfolio Beating Its Benchmark?)
Based on the results of the Cremers and Petajisto study, Active Share is another tool that can be added to an investor\'s toolbox for use in evaluating potential mutual fund investments. As the research hits the marketplace, more emphasis is likely to be placed upon it, making it more available and easier for investors to use.