In 2009 Martijn Cremers from the University of Notre Dame and Antti Petajisto New York University (NYU) published a research paper introducing a new method for evaluating active fund managers. The researchers’ paper presented the term ‘ High Active Share ,’ a metric for analyzing the share of portfolio holdings that differ from the benchmark index holdings.
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By computing Active Share for domestic equity mutual funds from 1980 to 2003, the paper discovered that funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence.
High Active Share Holding Key To Returns
Building on this initial paper, at the end of 2016 Cremers compiled another study (published in the Financial Analyst Journal) proposing the introduction of an ‘Active Fee’ instead of fixed cost for active managers based on data that shows managers with a high Active Share tend to outperform. However, the new paper proposes a slight adjustment to the traditional Active Share. This time around Cremers expresses Active Share as 100% minus the sum of the overlapping weights between the portfolio and its benchmark. Under the simplifying assumption that “one is solely interested in the relative performance to the benchmark (or assuming that both fund and benchmark have a similar risk), overlapping positions will not contribute to the relative performance.” For example, if the fund and its benchmark both have a 5% weighting in Apple, then the “actual performance of Apple stock is irrelevant for the relative performance of the fund, as Apple’s stock return will affect the fund and its benchmark identically.”
The paper also considers how investors can evaluate fund managers by their Active Share scores on the three pillars of active management – skill, conviction, and opportunity.
Active Share does not directly measure any of these factors, but it can be used to help build an assessment of each criterion. For example, the paper points out that the lower the Active Share, the higher the hurdle that the active manager must overcome in her portfolio’s Active Share to achieve relative outperformance – a measure of skill. The paper notes:
“As example of an actively managed fund with a relatively low Active Share, the AQR Large Cap Momentum Fund as of 2015:Q1 (henceforth ‘AQR Momentum’) has a 49% Active Share with respect to the S&P 500 Growth benchmark, and a gross expense ratio of 0.84% per year for its N retail share class. Therefore, its positions need to outperform its benchmark – available at an annual retail cost of about 0.15% per year – on average by 0.84% - 0.15% = 0.69% per year, in order to outperform the benchmark (ignoring risk). Its low Active Share of 49% indicates that only about half of the portfolio can contribute to any outperformance, such that the Active Share of the portfolio should outperform by at least 0.69%/0.49 = 1.41% per year (i.e., its hurdle rate).”
This forms the basis of the proposed Active Fee. In the above example, the active fee would be (0.84% - 51%*0.15%)/49% = 1.56% per year. This Active Fee concept is not in itself a new idea, it was first introduced by Cremers and Curtis in 2016, although the concept of excluding overlapping holdings is a new idea. The paper also introduces the new concept of calculating expense ratios in light of the fund’s Active Share and the cost of investing in the benchmark.
By analyzing the performance of active mutual funds between 1990 and 2015 according to this new Active Share metric, and superimposing the idea of Active Fee, Cremers reaches several key conclusions. Firstly, Active Share allows one to distinguish between funds that do and do not engage in a lot of stock picking – separating out the closet indexers from the real active managers. Second, the data shows that by avoiding low Active Share funds that are not cheap, investors would have been more likely to avoid underperforming funds – a fascinating result considering the current active vs. passive debate. And third the paper finds that there’s no evidence high Active Share funds have underperformed on average in the long-term, suggesting that “investors interested in individual stock pickers could use high Active Share as a starting point for fund selection, but with no ex-ante expectation that the typical high Active Share fund is going to either underperform or outperform.”
Maybe it’s too early to call the death of active management after all?
Cremers, Martijn and Petajisto, Antti, How Active is Your Fund Manager? A New Measure That Predicts Performance (March 31, 2009). AFA 2007 Chicago Meetings Paper; EFA 2007 Ljubljana Meetings Paper; Yale ICF Working Paper No. 06-14. Available at SSRN: https://ssrn.com/abstract=891719 or http://dx.doi.org/10.2139/ssrn.891719