The holy grail for mutual fund investors is the ability to identify in advance which of the very few active mutual funds will go on to outperform in the future.
To date, the overwhelming body of academic research has demonstrated that past performance not only doesn’t guarantee future performance (as the required SEC disclaimer states), but 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 study 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.
Today I’ll update my survey of the literature on active share as a performance predictor, published earlier this year, to include some additional research on the topic.
Revisiting Older Studies
We’ll begin by returning to our discussion of the 2009 Cremers and Petajisto study. After publication, questions were raised about its findings. I myself raised several issues. Among them were: