Swedroe: Active Share No Indicator Of Outperformance

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:

• 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, therefore increasing the probability of picking a fund that underperforms. Thus, investors are paying more for the privilege of experiencing greater risk without any compensation in the form of greater returns. Investors are best served by remembering this finding from another Vanguard study: The most reliable predictor of future results is a fund’s expense ratio.

New Research

Petajisto updated his study in 2013, adding six more years of data. Again he found: “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% 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%.

Using the same database that was used in 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 and presented their findings and conclusions in their April 2015 paper, “Deactivating Active Share,” which was published in the March/April 2016 issue of the Financial Analysts Journal. Before summarizing their findings, we need to address an important misconception that is held by many—in order to outperform, it’s necessary for a fund to have a high active share. The authors dispel that theory with a simple example.

“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 93 bps/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 example clearly demonstrates that having a high active share isn’t a requirement for outperformance. 

Following is a summary of the findings from the AQR paper:

• The study authors don’t find strong economic motivations for why active share may correlate with performance.
• The study authors find that the empirical support for the measure is weak and is entirely driven by the strong correlation between active share and the benchmark type—high active share funds and low active share funds systematically have different benchmarks. A 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 choice of comparing funds using benchmark-adjusted returns rather than total returns. Over this sample period, small-cap benchmarks had large negative four-factor alphas compared to 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.

Frazzini, Friedman and Pomorski 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 further explain: “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).”

Additional Findings
The authors also addressed another important issue that is related to the theory behind active share. They explain: “active share is only one measure of ‘activity’ or concentration in a portfolio. 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.” They note that the authors of the 2012 Vanguard study looked at five different measures of active management and found no evidence that they predict performance: “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.”

The authors concluded that neither theory nor data justify the expectation that active share might help investors improve their returns. The bottom line is this: Once returns were controlled for benchmarks, the performance difference between stock pickers and closet indexers (raw, benchmark-adjusted or alphas), while positive, wasn’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 the “much ado” made by the active management community regarding active share appears to be much ado about nothing. 

We’ll pick up this conversation later in the week when I look at active share and turnover and in emerging markets.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.