As I’ve proposed before, the holy grail for mutual fund investors is a mechanism to identify in advance which of the very few actively managed funds will go on to outperform in the future.
Despite a considerable body of academic research having demonstrated that past performance not only fails to guarantee future results but has virtually no value whatsoever as a predictor, believers in active management were offered hope the holy grail had been found with the advent of active share.
In a study published in the September 2009 issue of The Review of Financial Studies, “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” Martijn Cremers and Antti Petajisto concluded: “Active Share predicts fund performance: Funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence.”
Active share is a measure of how much a fund’s holdings deviate from its benchmark index, and funds with the highest active shares tend to have the best performance. Thus, while there’s no doubt that, in aggregate, active management underperforms, and that the majority of active funds underperform every year (and the percentage that underperform increases with the time horizon studied), if an investor is able to identify the few future winners by using active share as a measure, active management can be the winning strategy.
Lack Of Supporting Evidence
Unfortunately, subsequent research has found problems with the conclusions drawn by Cremers and Petajisto. For example, criticism has included arguments that the authors’ findings were due to the choice of benchmark, and that their results were skewed by the returns of a few very small funds.
Then, in May 2012, Vanguard’s research team examined the issue of active share as a predictor. Their study covered the 1,461 funds available at the beginning of 2001, and their final fund sample comprised 903 funds. Because the study only addressed surviving funds, survivorship bias exists in the data. Vanguard’s researchers found that, even with survivorship bias, with proper benchmarks, higher levels of active share didn’t predict outperformance.
Later, Andrew Ang, Ananth Madhavan and Aleksander Sobczyk of BlackRock, in their study “Estimating Time-Varying Factor Exposures,” which was published in the fourth quarter 2017 issue of Financial Analysts Journal, provided an out-of-sample test (after 2009) of Cremers and Petajisto’s findings.
They found that the measure of active share proposed by Cremers and Petajisto actually was negatively correlated (-0.75) to fund returns after controlling for factor loadings and other fund characteristics. Thus, they concluded it’s “not the case that high-conviction managers outperform.”
Morningstar conducted another out-of-sample test using data from 2001 through 2015. It found that, after adjusting for the market beta, size, value and momentum factors, there was no predictive value in active share. The only thing that active share predicted, which should be expected, was a wider dispersion of performance outcomes.
The most recent contribution to the literature on active share is the December 2017 study “Defining Activeness: Active Share, Risk Share & Factor Share.” The authors, Emlyn James Flint, Anthony Seymour and Florence Chikurunhe, examined South African funds over the period June 2003 through March 2017.
Once the results were adjusted for exposures to risk, they found that “there is no discernible relationship between current active share and future active return.”
The bottom line is that, in the face of all the evidence, it seems extremely hard to make the case that active share has any predictive value in terms of future risk-adjusted outperformance. Despite this, active share seems to be becoming an increasingly popular metric both in terms of reporting and evaluation.
Given the evidence, there doesn’t seem to be a logical explanation for the phenomenon, other than high active share is a necessary ingredient for outperformance. Unfortunately, it’s not a sufficient one.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.