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.