The holy grail for mutual fund investors is the ability to reliably and successfully identify, in advance, the very few active funds that will go on to outperform. To date, an overwhelming body of academic research has clearly demonstrated that past performance not only fails to guarantee future performance (as the required SEC disclaimer states) but has virtually no value whatsoever as a predictor.
Perhaps the only value past performance holds for investors can be found in the fact that poor performance tends to persist, with the likely explanation being high expenses.
In his December 2010 paper, “Active Share and Mutual Fund Performance,” Antti Petajisto claimed he had found this holy grail. Active share is a measure of how much a fund’s holdings deviate from its benchmark index. Funds with the highest active shares tend to have the best performance.
Thus, according to Petajisto, while there’s no doubt that, in aggregate, active management underperforms, because the majority of active funds underperform every year and the percentage of underperforming active funds increases with the time horizon studied, an investor should be able to prospectively identify those few future winners by using an Active Share measure.
As a result, active management can, in theory, become the winning strategy. You need only use the measure of Active Share to identify the future generators of alpha.
In January 2011, I raised several issues with Petajisto’s findings. Among them were:
- His results could be due to a skewed distribution. A few highly concentrated funds may have enormous returns, increasing the average for the stock pickers. It would have been helpful to report the median. This would have given us an indication of whether or not the probability of picking a winning fund is above 50 percent. As it stands, we don’t have any idea of the likelihood a winning fund can be selected.
- When mutual funds are sorted by both fund type and fund size, only the very smallest quintile of stock-picking funds displayed a statistically reliable abnormal return. This tells us 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 effect of incubation bias could be driving his results. Incubation bias results when a mutual fund family wishing to launch a new fund nurtures several at the same time. Funds that beat their benchmarks go public, while the 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.
Vanguard Weighs In
In May 2012, Vanguard’s research team took a look at the issue of Active Share as a predictor.
Its study covered the 1,461 funds available at the beginning of 2001. A total of 503, or 34.4 percent, were merged or liquidated over our period of analysis, and 55 others had missing data. The final fund sample comprised 903 funds. Because the study only covered surviving funds, there’s survivorship bias in the data.
To determine the predictive value of Active Share, Vanguard divided the data into two five-year periods. The five years from 2001 through 2005 was the evaluation period, and the six years from 2006 through 2011 was the performance period. The researchers used 60 percent 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. Said another way, investors paid more for the privilege of experiencing greater risk without any compensation in the form of greater returns. Investors are better served by remembering this finding from another Vanguard study: The most reliable predictor of future results is a fund’s expense ratio.