Active Share Can Be Useful, but It’s Not a Crystal Ball
Investors are always searching for simple answers, especially when it comes to evaluating mutual funds. It is easy to be overwhelmed by the ease of access to a plethora of quantitative data points. Knowing which ones are important and relevant can be a challenge, especially as new data points are introduced. Active share, though not new, gained popularity this year after New York state’s attorney general announced an agreement with the largest mutual fund companies to disclose the data point on every actively managed mutual fund in their lineups. Also this year, Morningstar said it would add active share to its website, allowing investors easy access to the data point. While greater transparency sounds like an improvement, investors need to understand what exactly active share is and what it can (and cannot) tell them.
The Nuts and Bolts
Active share was first introduced in the 2000s by professors at the Yale School of Management. The idea was to measure how "active" an active manager truly was in order to flush out closet index funds (that is, index-like funds masquerading as actively managed funds). This was an important concept at the time because investment management fees were coming under pressure from passively managed options, including index funds and ETFs. If investors could find (and avoid) the closet indexers, they could potentially save a lot of money in fees. After all, why pay active management fees for index-like returns?
Active share is a simple concept to understand—it is the percentage of stock holdings in a portfolio that differs from the benchmark’s holdings. In addition to considering the mere presence or absence of a stock in either the benchmark and/or the portfolio, it also considers the weight of each stock and how it differs. A larger active share equates to a more "active" portfolio, or one that looks dissimilar from the benchmark. This data point allows investors to make a more clear-cut decision around how different a manager is from its benchmark and whether she considers the fee appropriate given that information.
What active share does not do, however, is tell you whether an active manager’s bets are "good" or "bad". A manager with a portfolio that is similar to the benchmark (low active share) does not mean that manager is doomed to match or trail the benchmark. Similarly, a high active share does not imply that the manager will beat the benchmark, despite the insinuation by many fund providers that it does just that. A fund with high active share simply means its underlying holdings are different from the benchmark, either by individual security weights, including stocks not in the benchmark, or by excluding stocks held in the benchmark. The high active share manager could be very wrong—avoiding benchmark stocks that do well and/or purchasing out-of-benchmark stocks that subsequently underperform. While a fund that looks less and less like the benchmark may court higher risk, it’s unclear whether that added risk leads to higher returns. Various studies have shown contradictory results on that question.
It’s also important to note that small cap strategies tend to have higher active share than their large cap counterparts. A 2013 study by Fidelity Investments found that most small cap funds had active shares between 95% and 100% while most large cap funds’ active shares were much lower around 75%. The benchmark against which active share is measured also matters significantly and can vary by fund, making comparisons difficult. In fact, a 2015 study by AQR Capital Management found that most of the historical outperformance of high active share over low active share funds can be attributed to benchmark choices.
Active share, or any single data point, is not a silver bullet. It cannot tell investors what the future performance of an active manager will be, but it can help investors make more informed choices about which funds they own. If a manager charges a high fee and claims she is very active in stock picking, investors now have a way to fact check that claim, though additional diligence is required to confirm the benchmark used in the calculation is appropriate. Conversely, if a manager has a low active share, investors can decide whether paying a fee higher than an index option (even if only modestly higher), is worth it. All told, active share can be a useful data point if used in the proper context.