How much active management is being done by your mutual fund manager? Active Share may give you the answer.
In financial literature, there are numerous citations of studies showing the average mutual fund manager underperforms their benchmark index after fees. In 2006, 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 who do outperform.
- Active Share tracks the disparity between a portfolio manager's holdings and that of its benchmark index.
- Over the long run, actively-managed portfolios that try to beat their benchmark tend to underperform, on average (especially after taxes and fees).
- A low Active Share score indicates a portfolio manager is closely replicating the target index and engaging in a passive investment strategy.
The Research Behind Active Share
Active Share is a measure of the percentage of stock holdings in a manager's portfolio that differs from the benchmark index. Managers with high Active Share have been found to outperform their benchmark indexes and Active Share significantly predicts fund performance. Examining 2,650 funds from 1980 to 2003, Cremers and Petajisto found 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. This is surprising, since other researchers have repeatedly shown that active mutual fund managers, in general, both in the USA and abroad, consistently underperform their benchmark index, and ‘provides evidence that by and large market prices do seem to reflect all available information.’
Active Share is also useful in identifying closet indexers—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.
The Yale study also found funds tended toward low Active Share. The study states the percentage of assets under management (AUM) with an 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 an 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 Active Share and excess performance is higher among funds with fewer assets under management.
More recent studies also confirm that, on average, actively managed portfolios underperform their benchmark indexes, finding that over the 15-year period from 2002 to 2017, only about 8% of active funds were able to outdo passive indexes. After accounting for taxes and the trading costs generated by active management, the number of successful funds drops to just 2%.
Measuring Active Management Activity
The traditional measurement of the extent of active management employed by a mutual fund relies on methods comparing a fund's historical returns to those of its benchmark index. One such method, tracking error volatility, measures the standard deviation of the difference between a manager's returns and the index returns.
High tracking error volatility indicates a high degree of active management. The logic behind the measurement is 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 and the weight of each holding in the benchmark index and dividing by two.
Active Share = 21i=1∑N∣wfund,i − windex,i∣
As a simple example, suppose a benchmark index includes only one stock. If a manager decides they like 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%.
Active Share = 21(∣100%−50%∣+∣0%−50%∣) = 50%
The Active Share number in this example is essentially saying 50% of the manager's portfolio differs from the benchmark index.
A Word of Caution
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 the group. It would be wrong for investors to interpret the results in a manner leading them to conclude all managers with high Active Share portfolios will beat their benchmarks. The data only indicates 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 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 who 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.
The Bottom Line
Based on the results of the Cremers and Petajisto study, Active Share is another tool to add to an investor's toolbox for use in evaluating potential mutual fund investments.