I was recently asked to comment on Jason Voss’ CFA Institute article “Is Active Management Dead? Not Even Close.” The author claims that while most active managers fail to achieve superior risk-adjusted returns, it’s possible to identify the future winners by examining metrics such as active share. “Research shows a fund that consistently pursues a narrowly defined strategy, takes high conviction positions, and experiences considerable tracking error outperforms over the long-run.”
Research On Active Share
To address that claim, we can review the literature. In his December 2010 paper, “Active Share and Mutual Performance,” Antti Petajisto claimed he had found what might be called the Holy Grail of investing. Active share is a measure of how much a fund’s holdings deviate from its benchmark index, and the funds with the highest active shares have the best performance. Thus, while there’s no doubt that, in aggregate, active management underperforms and the majority of active funds underperform every year (the percentage that underperform increases with the time horizon studied), an investor can identify the few future winners by using the measure of active share. Therefore, active management can be a winning strategy—you only need use the measure of active share to identify those future alpha generators.
My blog post of January 5, 2011, “Does the Evidence Behind Active Share Hold Up?”, raises several issues with Petajisto’s findings. Among them are:
- His results could be due to a skewed distribution; a few highly concentrated funds may have had enormous returns, increasing the average for the stock pickers. It would have been helpful to report the median return. This would have given us an indication of whether or not the probability of picking a winning fund is above 50%. As it is, we don’t have any idea of the probability of picking a winning fund.
- When funds are sorted by both fund type and fund size, only the very smallest quintile of stock-picking mutual funds showed a statistically reliable abnormal return. This tells us that 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 incubation bias could be driving the results. (Incubation bias results when a mutual fund family wishing to launch a new fund nurtures several at a time. Funds that beat their benchmarks go public, while 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.
In its May 2012 Vanguard paper, “The Search for Outperformance: Evaluating ‘Active Share,'” Todd Schlanger, Christopher Philips and Karin Peterson LaBarge looked at the issue of active share as a predictor. Their study covered the 1,461 funds available at the beginning of 2001. A total of 503, or 34.4%, were merged or liquidated over our analysis period, and 55 others had missing data. The final fund sample comprised 903 funds. Because the study only covered surviving funds, survivorship bias is inherent in the data.
To determine predictive value of active share, Vanguard divided the data into two periods. The five years from 2001 through 2005 was the evaluation period, and the six years from 2006 through 2011 was the performance period. They used 60% active share as the breakpoint to indicate high or low levels of stock selection. The following is a summary of their conclusions: