It is generally assumed that active investment management is better than passive management, but real world studies have shown that this assumption is not always accurate. Just how active a portfolio manager should be is an oft-discussed question, and there is no general consensus save that it is definitely possible to be too passive” or “too active”.
One method of measuring “activeness” in investing that has been recently developed is called “active share”. The idea behind active share is to analyze the net deviation between the weights of stocks in a portfolio from their weights in a benchmark portfolio. A low active share portfolio closely matches a benchmark, and a high active share portfolio less closely matches a benchmark.
Active share has become a popular method to measure just how “active” the management of a fund really is, especially when used together with tracking error.
In a recent research report examining active share, Nomura analysts Joseph Mezrich and Yasushi Ishikawa note: “The conventional wisdom today seems to be that high active share helps active fund managers.”
However, after crunching the numbers, Mezrich and Ishikawa come to a different conclusion. “Based on data going back to 2004, our conclusion is that active share has not been a reliable indicator of fund manager success, at least not over the past decade, and may be overrated as an investment tool.”
Cremers and Petajisto developed the concept of active share in 2009. One advantage of active share together with tracking error is that it offers a useful method for characterizing investment approaches. Stock pickers typically have high active share. If they also have a low tracking error, they can be called diversified stock pickers. However, if their tracking error is high, they are making concentrated stock selections.
If a manager has low active share and a high tracking error then he is making factor bets. Factor bets mean not just overweighting growth or value or momentum, but also sector overweights not focused on specific stocks in the sector. If both active share and tracking error are low, then the investor could be considered a “closet indexer”.
A study by Petajisto in 2013 found that low active share managers typically underperform their benchmarks after fees, but high active share managers can add value if they have a relatively low tracking error. The key conclusion is that stock pickers can outperform if they avoid over-concentration.