Active Share: An Increasingly Relevant Measure

April 09, 2014 | Eric Gaylord, CFA, Partner

The popularity of passive or indexed investment strategies is as high as ever due to low costs, strong recent performance, and compelling research by the likes of Eugene Fama indicating active management is a losing endeavor in aggregate. Nevertheless, as more assets move to passive strategies from active, skillful active management becomes more attractive assuming market pricing is not perfectly efficient.

While the average active manager underperforms the market after fees, there are both successful and unsuccessful managers within the herd. The above table includes a sample of the results from a research study titled “Active Share and Mutual Fund Performance” by former Yale and NYU professor Antti Petajisto. The results of the study indicate that a specific subset of active mutual fund managers, specifically those with high Active Share, have exhibited persistent relative outperformance on a net-of-fees basis.

Active Share is a measure of how different a portfolio’s positions are from those of the passive index. The results of Petajisto’s study suggest that, on average, managers with high Active Share (i.e., Concentrated or Stock Picker type) outperform active managers with low to moderate Active Share. In fact, managers with both high Active Share and lower portfolio turnover actually outperformed the passive index net-of-fees by an average of 1.26% per annum with only slightly higher than average tracking error. A reasonable interpretation is that managers can be successful if they take active positions in strong companies and maintain conviction over time in those investments, avoiding excessive turnover. Meanwhile, managers with the lowest Active Share, termed Closet Indexers, persistently underperformed despite having the lowest fees and greatest diversification. This is unsurprising because these managers act mostly like the index but still charge fees reflective of active management. It is notable that large-cap stock strategies are more commonly closet indexers than small-cap strategies, and funds with too many assets under management have operational inability to take high active share.

In summary, there is a place in many portfolios for both active and passive management. The data does not indicate that all managers with high Active Share will outperform. Nevertheless, evaluating a manager’s Active Share in combination with other qualitative and quantitative factors can be very useful. Through due diligence, an independent investment consultant can help investors distinguish active managers who are more likely to exhibit talent and conviction. More importantly, if investors in so-called closet index funds were to move 60% of their money to a high Active Share manager and 40% of their money to a passive strategy, they could achieve the same level of Active Share while decreasing fees and increasing expected alpha. Take caution though: only patient investors who are comfortable with short-term tracking error can expect to realize the benefits of Active Share strategies, a virtue not exhibited by all.