Active share has become an increasingly popular metric among financial advisors to help them choose among the thousands of mutual funds available to clients.  It separates the truly actively managed funds dependent on the stock-picking ability of their managers from funds that more closely resemble their benchmark index — also known as “closet index funds.” It does this by comparing a fund’s assets to those of its benchmark index; the smaller the overlap, the larger the active share, and vice versa.

Two professors from the Yale School of Management — K. J. Martijn Cremers and Antti Petajistoy — popularized the concept in a study that found that within a particular investment category, funds with greater active share outperformed funds with lower active share over a 13-year period from 1990 to 2003, later extended to 2009.

The study also found that after accounting for fees and trading costs, funds with lower active share often underperformed their benchmarks. It concluded that the relatively high management fees of high active share funds were justified.

Many advisors and investors have used the study as an incentive to invest in funds with a high active share, along with their relatively higher fees, and fund companies have used the results to promote their actively managed funds. But Andrea Frazzini, a partner at AQR (Applied Quantitative Research), a global investment management firm co-founded by Cliff Asness, says this misinterprets the study’s results.

“It’s hard to find statistical evidence that high active share funds end up with better returns,” Frazzini told ThinkAdvisor. “For a given benchmark there is no evidence that higher active share or low active share have different returns.”

Among the problems with the conventional interpretation of the study, says Frazzini, is the fact that during the time period of the study, small-cap and mid-cap funds outperformed large-cap funds, and they tend to have a higher active share than large-cap funds. “You were better off with small- and mid-cap managers, not high active share funds,” says Frazzini.

Frazzini, who spoke with ThinkAdvisor days after presenting his argument at last week’s Morningstar ETF conference, says advisors are better off using the concept of active share as a measure of risk in a particular portfolio, not better performance.

He explained:  Since active share measures a fund’s deviation from its benchmark, the less diversified the fund — the more concentrated the number of stocks — the higher the active share and risk. Neither mean the performance will be greater but they can be used to judge higher fees. Frazzini prefers the corollary: “If a manager is not taking a lot of risk he should not be commanding a lot in fees.”

So why the appeal of active share? “It’s a very simple measure and intuitive,” says Frazzini. “It measures how you’re deviating from a benchmark. It’s easy to explain.”

But he  notes that while some funds that have taken more risk have outperformed, other funds taking on more risk have lagged. “Look at the winners versus the losers,” says Frazzini.

He says it’s possible that active share could be an indicator of better performance, but it will take at least another 30 years to gather enough evidence for that.

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