These days, most financial advisors have at least a passing familiarity with Active Share. That’s the analysis system created in 2006 by Martijn Cremers and Antti Petajisto (professors at the Yale School of Management at the time), which identifies actively managed mutual funds that have the best chance of outperforming their index bogey. For those who aren’t familiar, Active Share calculates the percentage of a fund’s holdings that are over-weighted or under-weighted compared to that fund’s target index. Based on the logic that a fund can’t outperform its index if it holds the same stocks as the index, the greater the concentration of stocks outside of the index, the greater chance a given fund will outperform that index.
Active Share, then, is method of determining which actively managed funds have the best chance of generating returns that will justify their expense ratios, which tend to be quite a bit higher than funds or ETFs that simply hold their target index. Consequently, many advisors use Active Share to help identify the most promising active funds—and to justify those recommendations to their clients.
In these times, when a growing body of critics are claiming that including any funds in clients’ portfolios that aren’t index mutual funds or ETFs is tantamount to advisory malpractice, the Active Share data provides a powerful response. But to my mind, the Active Share system also provides a credible answer to an even more pressing question. Why should investors pay a human advisor, when they can hire a “robo advisor,” which uses index mutual funds or ETFs, for a fraction of the cost?
As I said, in principle, any way, the Active Share concept is pretty simple: the higher the percentage difference between the stocks in a given fund and the stocks in its bogey, the better the chance the fund will outperform that bogey. However, the astute reader will quickly realize that the converse of that statement is also true: the greater the chance that the fund will underperform its index bogey—it’s hard to underperform if you closely mirror your index. (Cautious fund managers also have figured this out so they tend to track their bogeys pretty closely, In turn, that is what gives rise to the questions about whether their higher-than-the-index management fees are justified.)
But Cremers and Petajisto’s data revealed another interesting trend. According to Touchstone Investments’ white paper, A Measure of Active Management. “After developing the concept of Active Share, Cremers and Petajisto performed a study to see whether Active Share had any bearing on the relative performance of domestic all-equity mutual funds,” the white paper reports. What the researchers found was that historically “funds with the highest Active Share [that is, percentage of different holdings vs. their target index] significantly outperformed their benchmarks, both before and after expenses, and they exhibited strong performance persistence.”
Specifically, they found that from 1990 to 2003, the 20% of equity funds with the highest “Active Share” percentage outperformed their benchmark index by an average of 1.4% per year—net of all fees and transaction costs!
Let’s be clear here, because this is important. Not only does a larger Active Share percentage give a fund a greater chance of outperforming their indexes, the funds with the higher Active Share actually outperform their indexes. Put another way, Cremers and Petajisto’s data shows that active management actually works: on average, the more active the manager, the higher their funds’ investment returns.
To find out why truly active managers tend to outperform, I had a conversation with Steve Graziano, president of Touchstone Investments in Cincinnati, which offers a family of funds that all have a top 20% Active Share rating.
“Of course, the best performing fund managers don’t just pick stocks because they aren’t in their target index,” Graziano told me. “In today’s environment, with so much attention focused on indexes, managers have to have a real conviction that their Active Share stocks truly have greater potential. That kind of commitment comes from having a proven, repeatable discipline."
Those managers, he said, also tend to hold onto their stocks longer, "which reduces risk and keeps expenses down." They also tend to have more concentrated portfolios, of between 25 and 30 stocks, Graziano said, "which is more than enough for diversification, but are easier to monitor, and therefore, of consistently higher quality.”
There you have it. In today’s world, if you’re going to survive as a truly “active” manager, you have to be pretty darn good at:
- sticking to a stock picking system that works
- not spreading yourself too thin
- and believing in the stocks you’ve picked.
Over time, you’ll outperform.
If you’re going to survive as a financial advisor—and keep charging those 50 bps to 100 bps portfolio management fees—you increasingly will have to demonstrate that you’re adding value, too. Especially in volatile markets, like the one we have now.
I suspect that Active Share may be the tool that helps advisors to do just that: it shows that active management does add value. But not just any active manager.
And whether you identify those managers yourself, or use a family of funds like Touchstone to help you, I think it will be a long time before the robos create an algorithm to make those qualitative judgments.