As I have explained before, the holy grail for which many investors are searching is the ability to identify in advance which of the very few actively managed funds will go on to outperform in the future.
An overwhelming body of research has demonstrated that past performance not only doesn’t guarantee future performance, it has virtually no value whatsoever as a predictor. The only value of past performance seems to be that poor performance tends to persist—with the likely explanation being high expenses.
Believers in active management were offered hope that the holy grail had been found with the publication, in the September 2009 issue of The Review of Financial Studies, of a paper by Martijn Cremers and Antti Petajisto, “How Active Is Your Fund Manager? A New Measure That Predicts Performance.”
The authors 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. Unfortunately, subsequent research has found active share is not a good predictor of future mutual fund performance.
Hedge Funds & Active Share
Ekaterini Panopoulou and Nikolaos Voukelatos contribute to the literature on the performance of hedge funds, and indirectly on active share, with their October 2017 study, “The Role of Strategy Distinctiveness in Hedge Fund Performance.”
They observe that hedge funds are able to charge investors high fees based on the expectation they will deliver superior performance. This superior performance must be driven by fund managers possessing unique skills that allow them to pursue unique investment ideas.
Panopoulou and Voukelatos tested this hypothesis by examining whether hedge funds with high degrees of distinctive strategy showed persistent outperformance. Their measure of strategy distinctiveness is based on a fund’s return-distance (a measure similar to active share, and the distance of a fund’s return from the mean return of its cohort, scaled by the mean distance among all the cohort’s funds).
They label this measure the fund’s dispersion contribution index (DCI). They then examined whether higher levels of strategy distinctiveness are associated with superior performance after accounting for the fund’s risk exposure.
DCI offers the following benefits: First, it’s a logical choice, as a fund manager can only substantiate the claim of delivering value through unique strategies by oﬀering returns that deviate from peers. Second, the data is readily available, with no need to observe a hedge fund’s holdings.
Their study covered the period January 1994 to August 2015, and included almost 23,000 unique funds. Following is a summary of their findings:
- While the DCI for the majority of funds is less than 1, a small number of funds have particularly high DCI levels.
- The DCI of an individual fund is considerably persistent over time.
- The DCI is signiﬁcantly related to other fund characteristics. Higher DCI levels are more likely to be observed in funds with higher return volatility, longer redemption notice and lockup periods, higher performance fees, lower age and higher leverage.
- While funds with the highest (lowest) DCI indeed have provided the highest (lowest) net returns, when other sources of risk and other fund-speciﬁc characteristics were accounted for, there was strong evidence that more-distinctive funds underperformed relative to their less-distinctive peers. The higher raw returns were accompanied by greater idiosyncratic risks, greater volatility and greater downside risks, and the overall trade-off was negative. These results were robust to various measures of risk-adjusted returns and to other tests (such as equal-weighting or value-weighting).