The holy grail for mutual fund investors is the ability to reliably and successfully identify, in advance, the very few active funds that will go on to outperform. To date, an overwhelming body of academic research has clearly demonstrated that past performance not only fails to guarantee future performance (as the required SEC disclaimer states) but has virtually no value whatsoever as a predictor.
Perhaps the only value past performance holds for investors can be found in the fact that poor performance tends to persist, with the likely explanation being high expenses.
In his December 2010 paper, “Active Share and Mutual Fund Performance,” Antti Petajisto claimed he had found this holy grail. Active share is a measure of how much a fund’s holdings deviate from its benchmark index. Funds with the highest active shares tend to have the best performance.
Thus, according to Petajisto, while there’s no doubt that, in aggregate, active management underperforms, because the majority of active funds underperform every year and the percentage of underperforming active funds increases with the time horizon studied, an investor should be able to prospectively identify those few future winners by using an Active Share measure.
As a result, active management can, in theory, become the winning strategy. You need only use the measure of Active Share to identify the future generators of alpha.
In January 2011, I raised several issues with Petajisto’s findings. Among them were:
- His results could be due to a skewed distribution. A few highly concentrated funds may have enormous returns, increasing the average for the stock pickers. It would have been helpful to report the median. This would have given us an indication of whether or not the probability of picking a winning fund is above 50 percent. As it stands, we don’t have any idea of the likelihood a winning fund can be selected.
- When mutual funds are sorted by both fund type and fund size, only the very smallest quintile of stock-picking funds displayed a statistically reliable abnormal return. This tells us the only funds that generated reliable outperformance were the very smallest of the stock pickers. This reinforces the idea that skewness could be driving the results.
- The smallest funds typically are young funds. Thus, the well-documented effect of incubation bias could be driving his results. Incubation bias results when a mutual fund family wishing to launch a new fund nurtures several at the same time. Funds that beat their benchmarks go public, while the poorly performing ones never see the light of day. If this bias exists, the reported returns for small funds don’t mean much.
- The persistent performance of the best stock pickers could also be due to incubation bias.
Vanguard Weighs In
In May 2012, Vanguard’s research team took a look at the issue of Active Share as a predictor.
Its study covered the 1,461 funds available at the beginning of 2001. A total of 503, or 34.4 percent, were merged or liquidated over our period of analysis, and 55 others had missing data. The final fund sample comprised 903 funds. Because the study only covered surviving funds, there’s survivorship bias in the data.
To determine the predictive value of Active Share, Vanguard divided the data into two five-year periods. The five years from 2001 through 2005 was the evaluation period, and the six years from 2006 through 2011 was the performance period. The researchers used 60 percent Active Share as the breakpoint to indicate high or low levels of stock selection. The following is a summary of their conclusions:
- Even with survivorship bias in the data, higher levels of active share didn’t predict outperformance.
- Contrary to conventional wisdom, “high-conviction funds” with high active share didn’t significantly outperform low-active-share funds.
- The higher the active-share level, the larger the dispersion of excess returns.
- The higher the active-share level, the higher the fund costs.
The bottom line is that, while active share didn’t predict performance, it did increase risks as the dispersions of returns increased. Said another way, investors paid more for the privilege of experiencing greater risk without any compensation in the form of greater returns. Investors are better served by remembering this finding from another Vanguard study: The most reliable predictor of future results is a fund’s expense ratio.
Petajisto updated his study in 2013, adding six more years of data. He found that: “Over my sample period until the end of 2009, the most active stock pickers have outperformed their benchmark indices even after fees and transaction costs [by 1.26 percent per annum]. In contrast, closet indexers or funds focusing on factor bets have lost to their benchmarks after fees.” The specific recommendation was to avoid funds with active shares below 60 percent.
Using the same database employed by the Petajisto studies, Andrea Frazzini, Jacques Friedman and Lukasz Pomorski of AQR Capital Management examined the evidence and the theoretical arguments for active share as a predictor of performance. They presented their findings and conclusions in a March 2015 paper, “Deactivating Active Share.”
Before summarizing the study’s findings, we first need to address an important misconception held by many investors. Specifically, that in order to outperform, a fund necessarily must have a high active share. The authors dispel that theory with a simple example.
They write: “Consider a long-only, S&P 500-benchmarked manager who can predict which single stock will deliver the lowest returns over the subsequent month. Every month the manager avoids this one stock with the lowest return and, not having any other information, holds the remaining S&P 500 stocks proportionally to their index weights. From January 1990 through October 2014, this manager would have beaten the benchmark by 93bps/year before fees with an average Active Share of only 0.4%. If the manager dropped five stocks with the lowest returns, he would have outperformed by 4.51% per year with the average Active Share of only 2.2%.”
This scenario clearly demonstrates that having a high Active Share isn’t required for outperformance.
Following is a summary of the findings from the AQR Capital Management paper:
- We don’t find strong economic motivations for why active share may correlate with performance.
- We find that the empirical support for the measure is weak and entirely driven by the strong correlation between active share and benchmark type. High active share funds and low active share funds systematically have different benchmarks. The majority of high active share funds are small-caps and a majority of low active share funds are large-caps.
- While active share correlates with benchmark returns, it doesn’t predict actual fund returns. Within individual benchmarks, active share is just as likely to correlate positively with performance as it is to correlate negatively.
- Active-share results are very sensitive to the decision to employ benchmark-adjusted returns rather than total returns in fund comparisons. Over this sample period, small-cap benchmarks had large negative four-factor alphas when compared with large-cap benchmarks, and this was crucial to the statistical significance of the results.
- Controlling for benchmarks, active share has no predictive power for fund returns, predicting higher fund performance within half of the benchmark indexes and lower fund performance within the other half.
A Small-Cap Bias
The authors went on to explain: “Small-cap benchmarks, associated with high Active Share funds, underperform large-cap benchmarks which tend to be associated with low Active Share funds. The differences, estimated over 1990-2009, are substantial, with annualized alphas ranging from -3.35% for Russell 2000 Growth to +1.44% for S&P 500 Growth. The fitted regression line implies about 2% difference between the extremes, and in spite of having only 19 observations the slope is significant at the 1% level with a t-statistic of 2.92. The surprising underperformance of small-cap benchmarks is also discussed in Cremers, Petajisto and Zitzewitz (2013). One could speculate that in this sample period small-cap benchmarks were easier to beat for investors who could access value, size and momentum as defined in the academic literature. This is consistent with findings of other studies critical of Active Share that have observed that its performance predictability can be explained by a bias towards the small-cap sector.”
They write further: “If Active Share predicted performance, then the estimated Stock Picker minus Closet Indexer alpha should be positive. This happens in eight out of 17 benchmark indexes, and in only one is the relationship statistically significant. In each of the remaining nine benchmarks, higher Active Share predicts lower performance (in one benchmark significantly so).”
The authors also addressed another important issue related to the theory behind active share. They correctly observe that “Active Share is only one measure of ‘activity’ or concentration in a portfolio.” The authors continue: “If one argues that Active Share can predict performance, what about other measures of concentration? For example, tracking error captures similar dimensions as Active Share, and yet Cremers and Petajisto (2009) show that high-tracking-error funds do not outperform low-tracking-error funds.”
No Predictive Powers
The authors then note that the researchers behind the aforementioned 2012 Vanguard study looked at five different measures of active management and found no evidence that they predict performance.
They write: “Which then begs the question of what it might be that Active Share happens to capture some critical feature of what it means to be active and we just do not know what it is. Theory would be helpful here, but there is none. So why is Active Share so special that it is the only measure that seems to predict performance? One explanation is that it may just be a spurious, data-mined result.”
In the end, the authors conclude that neither theory nor data justify the expectation that active share might help investors improve their returns.
The bottom line is this: Once returns are controlled for benchmarks, the difference in performance between stock pickers and closet indexers (raw, benchmark-adjusted or alphas), while positive, weren’t statistically different from zero. In other words, for a given benchmark, there was inadequate evidence that high active share funds have higher returns than low active share funds.
The conclusion you might draw is that, although much has been made by the active management community regarding active share, it appears to be much ado about nothing.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.