Active share is hailed by some to be the holy grail in terms of its ability to identify future fund performance. My posts of April 24 and April 26 presented the evidence demonstrating that active share is likely another example of the triumph of hype and hope over facts.
Today we’ll look at two out-of-sample tests of the ability of active share to predict future fund performance. Out-of-sample tests are important, as their results reduce the risk that in-sample outcomes are random (a result of data mining).
A Canadian Study
The April/May 2017 issue of Morningstar presented the findings of its study “Active Share Doesn’t Live Up to Hype: An Unreliable Way to Forecast Winning Canadian Equity Funds.” The study covered the period January 2001 through December 2015.
Morningstar tested active share’s predictive power in two 10-year periods—2001-2010 and 2006-2015—dividing each 10-year period into two five-year periods. The first five years are the in-sample period used to calculate active share, and the second five years are the out-of-sample period.
Morningstar found virtually no differences in returns once exposure to the common factors of market beta, size, value and momentum were considered: “After accounting for those factors, funds delivered little to no alpha across active share levels.” The researchers also found virtually no difference when they examined the worst-case drawdowns.
Morningstar also noted that “higher active share many not ensure better results, but it is likely to lead to more extreme ones … The distribution of performance outcomes widened as active share rose.” In other words, investors were taking more risk of large losses (and investors are, in general, risk averse) without being compensated with higher returns—demonstrating that active share isn’t a totally useless measure after all.
Morningstar provided another out-of-sample test with its March 2016 study “Active Share in European Equity Funds: The Activeness of Large-Cap European Fund Managers Through the Lens of Active Share.”
Morningstar’s database is a set of large-cap European funds investing in European equities and encompasses the period January 2005 through June 2015. The researchers chose to include only large-cap funds to reduce the difficulties arising from benchmark selection and the impact of the small-cap effect.