Deactivating Active Share

Abstract

The authors investigate “active share,” a measure meant to determine the level of active management in investment portfolios. Using the same sample that was used by Cremers and Petajisto (2009) and Petajisto (2013), they find that active share correlates with benchmark returns but does not predict actual fund returns; within individual benchmarks, active share is as likely to correlate positively with performance as it is to correlate negatively. Their findings do not support an emphasis on active share as a manager selection tool or an appropriate guideline for institutional portfolios.

The summary was prepared by Pamela G. Yang, CFA.

What’s Inside?

Previous studies seem to indicate that high-active-share funds outperform their reported benchmarks and that the benchmark-adjusted returns of high-active-share funds are higher than the benchmark-adjusted returns of low-active-share funds. Some investors have interpreted these studies as implying that it is better to select fund managers with high active share. The authors question this interpretation. Using the same methodology and sample as those used in previous studies, the authors find no statistically significant relationship between active share and fund returns. However, although active share may not be useful for predicting outperformance, the authors point out that it may be useful for evaluating management fees.

How Is This Research Useful to Practitioners?

This study is important because the previous studies by Cremers and Petajisto (Review of Financial Studies 2009) and Petajisto (Financial Analysts Journal 2013) have attracted considerable attention and led certain investors, investment professionals, and regulators to believe that high-active-share funds achieve higher alphas than low-active-share funds.

The authors find three important results. First, high-active-share funds tend to have small-cap benchmarks, whereas low-active-share funds tend to have large-cap benchmarks. Thus, sorting funds on active share is similar to sorting on benchmark type, and the relationship between active share and mutual fund returns in excess of their benchmarks is driven by the correlation between active share and benchmark type. Second, the authors find no reliable statistical evidence that differentiates the returns of high-active-share funds and low-active-share funds from each other. Third, for a given benchmark, the authors do not find reliable statistical evidence that high-active-share funds earn higher returns than low-active-share funds.

This new study suggests that active share is not a valuable measure of managers’ skill. The authors remind us that active share is a measure of active risk and simply taking on more risk does not necessarily lead to outperformance. Because pursuing investment returns is in aggregate a zero-sum game, there will be winners and losers among high-active-share investors. But as a group, high-active-share investors cannot systematically outperform low-active-share investors (i.e., indexers).

However, the authors point out that active share may be useful in evaluating fees charged by fund managers. Fees should be in line with the active risk taken by the fund, but active share is only one of several measures used to determine the degree of “activity.” Other measures include predicted and realized tracking errors and other concentration measures. Using multiple measures in tandem could help investors identify managers who might be overcharging for the active risk they take.

How Did the Authors Conduct This Research?

The authors closely replicate the work of Cremers and Petajisto (2009) and Petajisto (2013) and use data on active share and benchmark assignment for all actively managed US domestic mutual funds from 1990 to 2009.

The analysis of the correlation between benchmark type and benchmark alpha shows that small-cap indexes (which tend to be the benchmark of high-active-share funds) underperformed large-cap indexes (which tend to be the benchmark of low-active-share funds). This result is consistent with those of Cremers, Petajisto, and Zitzewitz (Critical Finance Review 2013).

Following Petajisto (2013), the authors sort mutual funds into five active share portfolios on the basis of their active share results and realized tracking errors. Along with the average benchmark-adjusted returns to each active share grouping, they also show benchmark-adjusted returns regressed on factors (market, size, value, and momentum) to calculate alphas. They decompose annualized net-of-fee returns and alphas of the five active share portfolios into two elements: the contribution from fund returns and the contribution from each fund’s benchmark.

The results show that stock pickers (managers who are in the highest quintile of active share intersected with all but the highest quintile of tracking error) earn significantly higher benchmark-adjusted returns and alphas than closet indexers (managers who are in the lowest quintile of active share intersected with all but the highest quintile of tracking error). However, the decomposition shows that the difference in fund returns and alphas is statistically insignificant; only the difference in alpha between the benchmark indexes of the two active share portfolios (stock pickers and closet indexers) is statistically significant. In other words, the authors do not find reliable statistical evidence that high-active-share funds achieve higher returns or alphas than low-active-share funds; rather, benchmarks drive the difference in benchmark-adjusted performance between low- and high-active-share funds.

After controlling for benchmarks, the authors find that the performance difference between stock pickers and closet indexers, although positive, is not significantly different from zero. This result is consistent with the finding that the performance improvements associated with active share are driven by the correlation between active share and benchmark rather than by manager’s skill.

Abstractor’s Viewpoint

Are investors better off if they select active managers? Intuitively, certain investors expect that managers who “appear to do something active” will generate higher returns. Investors often do not realize that such an expectation is a myth. As the authors show, although active share correlates with benchmark returns, it does not predict actual fund returns. Diminishing the role of active share in assessing manager’s skill is important. Hopefully, using active share as a measure of manager’s degree of activity will save investors from paying fees to undeserving managers. But I doubt that the investment community will change its behavior by abandoning its pursuit of active share.

Editor’s note: The authors may have a commercial interest in the topics discussed in this article.

Editor’s note: This article was reviewed and accepted by Executive Editor Stephen J. Brown.