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 studies that show that 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 is said to indicate that a portfolio manager is closely replicating the target index and engaging in a passive investment strategy.
- A high Active Share score is said to indicate that a fund's holdings diverge from the target index and that the portfolio manager is outperforming it.
- These performance conclusions are surprising, given that research consistently shows that active fund managers underperform the benchmark indexes.
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. The conclusion drawn by the study is 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.
This is surprising, since other researchers have repeatedly shown that active mutual fund managers, in general, both in the United States and abroad, consistently underperform their benchmark index. This alternate research indicates that, for the most part, market prices reflect all available information.
According to the study, 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 obstacle to outperforming an index, for anyone holding a portfolio similar to a benchmark.
The Yale study also found funds that had low Active Share. 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 completely 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 that Active Share and excess performance are 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%.
According to Active Share, an index fund that matches its benchmark index precisely will have an Active Share score of 0. A fund that has no shares in common with the index will have an Active Share score of 100.
Measures of Active 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 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 that the makeup of individual stocks in a portfolio will be reflected in the pattern of the returns. If the returns of the portfolio deviate from the index's 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 implies actions the manager is taking 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 are supposed to 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 result in this example essentially means that 50% of the manager's portfolio differs from the benchmark index.
Investors Should Be Cautious
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 the high Active Share managers mentioned previously are an average of the group.
It would be wrong for investors 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 them. Investors who only rely on Active Share as an indicator of market-beating performance could inadvertently 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 consistent. Cremers and Petajisto find significant consistency in high Active Share managers' abilities to continue to deliver excess returns relative to a benchmark index.
What Does Active Share Do?
According to the Yale study of Cremers and Petajisto, Active Share can identify the amount of active management being conducted by mutual fund managers. Active Share compares the holdings of a fund to the holdings of its target index and measures the divergence. Those that closely resemble their index get a low Active Share score. Those funds whose holdings diverge get higher Active Share scores.
How Can Active Share Results Be Misinterpreted?
Investors might mistakenly believe that high Active Share scores for funds indicate managers who beat the benchmark. However, this would be a wrong interpretation. Active Share results point to an average performance for a group, not individual funds.
What Does Tracking Error Volatility Measure?
Contrary to Active Share's method of comparing actual security holdings, tracking error volatility measures the standard deviation of the difference seen in a fund manager's returns compared to an index's returns. A high volatility result implies a large amount of active management.
The Bottom Line
Based on the results of the Cremers and Petajisto study, Active Share may be another tool that investors can use to evaluate potential mutual fund investments. However, it should be used along with other analysis tools for a more complete understanding of performance potential.