Deactivating Active Share via SSRN

Andrea Frazzini AQR Capital Management, LLC Jacques Friedman AQR Capital Management, LLC Lukasz Pomorski
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AQR Capital Management, LLC April 21, 2015
Abstract:

We investigate Active Share, a measure meant to determine the level of active management in investment portfolios. We evaluate the claim that the measure predicts investment performance by considering theoretical arguments and via empirical analysis. We do not find strong economic motivations for why Active Share may correlate with performance. We also use the same data set used in the original Active Share studies (Cremers and Petajisto, 2009 and Petajisto, 2013) to evaluate the robustness of the empirical results from those studies. We find that the empirical support for the measure is weak and is entirely driven by the strong correlation between Active Share and the benchmark type. For example, Active Share correlates with benchmark returns, but does not predict actual fund returns; within individual benchmarks, Active Share is as likely to correlate positively with performance as it is to correlate negatively. We conclude that neither theory nor data justify the expectation that Active Share might help investors improve their returns.

AQR Capital Management: Deactivating Active Share – Introduction

Active Share is a metric proposed by Cremers and Petajisto (2009) and Petajisto (2013) (hereafter, C&P) to measure the distance between a given portfolio and its benchmark, and identify where a manager lies in the passive to active spectrum. It ranges from zero, when the portfolio is identical to its benchmark (totally passive), to one, when there is no overlap in names between the benchmark and the portfolio. Technically, Active Share is defined as one half of the sum of the absolute value of active weights:

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where wj = wj,fund ? wj,benchmark is the active weight of stock j, defined as the difference between the weight of the stock in the portfolio and the weight of the stock in the benchmark index. Using holdings and performance data of actively managed domestic mutual funds (from the Thomson Reuters and CRSP databases, respectively), C&P show that historically high Active Share funds outperform their reported benchmarks and that the benchmark-adjusted return of high Active Share funds is higher than the benchmark-adjusted return of low Active Share funds. They also provide investors with a simple rule of thumb: funds with Active Share below 60% should be avoided as they are closet indexers that charge high fees for merely providing index returns.

Not surprisingly, these results have attracted considerable attention in the investment community. In response, more-active mutual fund and institutional money managers tout their Active Share, several leading investment consultants strongly emphasize the measure, and online tools are now available to allow investors to screen managers based on Active Share.1 Institutional investors are more focused on asset managers with a high Active Share, and some have even embedded a high Active Share requirement in their investment guidelines. For example, a large public pension plan has added the following requirement to a recent request for proposals:

“The firm and/or portfolio manager must: (…) Have a high Active Share in the Small-Cap Strategy, preferably greater than 75% in the last three years”; furthermore “if the Active Share is lower than 75%, please clearly state that in the RFP response and explain why the Active Share is low and why it is beneficial.”

This white paper addresses Active Share from two perspectives. First, we investigate theoretical (ex ante) arguments for why Active Share may predict performance and potential misperceptions of Active Share. Second, we go to the data to evaluate the robustness of the empirical evidence behind this measure.

Overall, our conclusions do not support an emphasis on Active Share. Predicting investment performance is difficult and there do not seem to be any silver bullets. On the theory side, we believe there is little economic intuition that would justify a preference for high Active Share. A plausible economic story would require assumptions that are strong, far from obvious, and rarely made explicit by prior papers discussing the concept.

On the empirical evidence, we use the original data set to closely replicate the findings produced in C&P but we believe that their conclusions are subject to misinterpretation.2 We have three main results:

  • High Active Share funds and low Active Share funds systematically have different benchmarks. A majority of high Active Share funds are small caps and a majority of low Active Share funds are large caps.
  • The authors’ results are very sensitive to their choice of comparing funds using benchmark-adjusted returns rather than total returns. Over this sample, small-cap benchmarks had large negative four-factor alphas compared to large-cap benchmarks and this was crucial to the statistical significance of their results.
  • Controlling for benchmarks, Active Share has no predictive power for fund returns, predicting higher fund performance within half of the benchmark indexes and lower fund performance within the other half.

We agree with C&P on one point: fees matter, and if you deliver index-like returns, you should charge index-fund-like fees. In general, fees should be commensurate with the active risk funds take. There are many ways beyond Active Share to measure the degree of “activity” in a portfolio, including predicted and realized tracking error and other concentration measures. A prudent investor should use multiple measures to determine if a manager is taking risks commensurate with fees.

Active Share

See full PDF below.

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