What does active share tell us

Anyone familiar with the academic literature on active fund management will tell you two things. First, there’s shedloads of it, and secondly, it all concludes with pretty much the same thing — namely that active management is not a very efficient way to build long-term wealth.

It’s hardly surprising, then, that when a paper is published that appears to provide a more favourable assessment of active management, the fund industry welcomes it with open arms.

One such paper was the 2006 study by Martijn Cremers and Antti Petajisto which introduced a statistic called “active share”. Simply put, active share is a measure of how much a fund diverges from the index. So-called closet index trackers, which are still scandalously common, have very low active-share scores; funds with high-conviction managers that bear little resemblance to the index have high active-share scores.

Crucially, the paper claimed, funds with higher active-share scores outperformed those with lower scores.

“The industry was delighted,” Morningstar columnist John Rekenthaler recalls. “Its product managers published article after article about (it). There were even presentations that instructed marketers on how to use active share’s findings in their materials.”

The message conveyed to investors was simple: if you want to outperform the market, look for a fund that doesn’t invest like an index fund. The problem, of course, is that beating the index, especially after costs, is far from simple. Consistently spotting funds, in advance, that will do so in the long run is all but impossible.

Morningstar Manager Research has just published a study that puts active share into proper perspective. A team led by Robby Greengold analysed the performance of open-end mutual funds across the nine US-focused Morningstar Categories between January 2003 and December 2020. As you can tell from the paper’s title, Unattractive Share, the researchers are sceptical about active share as a tool for predicting outperformance.

This is what they found:

— Linkages between high active share and superior before-fee returns did not prevail across categories. Even in categories where high-active-share funds outperformed their low-active-share peers before costs, their higher fees substantially eroded their edge.

— Funds with high active share significantly underperformed those with low active share in four categories, both before and net of fees. High-active-share funds failed to deliver superior net-of-fee results in any category.

— Funds with relatively high active share cost 20 to 50 basis points more than those with low active share within the same category, as of year-end 2020.

— Across all categories, high-active-share funds exhibited higher risk than their low-active-share peers.

In a nutshell, to quote the authors, “since 2003, investors in high-active-share funds have mostly endured more risk while paying steeper fees for mediocre relative returns.”

Morningstar’s findings are consistent with those of researchers at AQR Capital Management. In a paper written five years ago, Deactivating Active Share, AQR concluded that although the idea that success requires high conviction may seem intuitive and appealing, there is no clear economic reason or theory to link “different” to “better”.

Interestingly, the researchers showed that the initial suggestion of a relationship between high active share and benchmark outperformance was down to a quirk in the data. High-active-share managers, they explained, tended to be small-cap managers, and small-cap benchmarks had negative alphas relative to the entire equity market. In other words, the high-conviction managers looked good because their benchmarks looked bad.

Properly adjusted, they concluded, “there is no evidence you’re more likely to be right just because you have a high conviction.” Although higher active share may lead to different returns, they won’t necessarily be higher returns. Indeed it’s just as likely for active share to be associated with underperformance as outperformance.

Conclusion
So what can we take away from this latest research? One conclusion we shouldn’t draw is that active share is completely without value. It’s a useful measure of how aggressive a particular fund manager’s investment style is. Most importantly, the focus on active share has helped to raise awareness of the on-going plague of closet index funds.

But active share is certainly not a predictor of outperformance. If you invest with a high-conviction manager, you can expect to pay higher fees and be exposed to higher risk. What you can’t expect is to beat the benchmark. High active share is a pre-requisite for generating alpha but, on its own, it’s definitely not sufficient.

ROBIN POWELL is a journalist and author and is the editor of The Evidence-Based Investor.