“Active share” is a misused tool that does not provide an accurate forecast of a fund’s future level of returns and is instead being used a justification to charge investors higher fees, according to passive giant Vanguard.
In research conducted for the passive house titled ‘The Urban Legends of Active Share’, Chris Tidmore, David J. Walker and Francis M. Kinniry found that, on average, higher active share funds – those whose portfolios differ more from their benchmark index – failed to outperform low cost, low active share funds.
Yet despite this conclusion, the authors found a high active share is often wrongly used as a way to predict future winners.
“Active share is designed to determine the degree of active management in an actively managed portfolio and, along with other measures, can be helpful as a manager evaluation tool,” the authors explained.
“It can be used to compare the appropriateness of different benchmarks and to check for consistency in a portfolio’s investment strategy over time. It does not, however, measure manager skill, and a myopic use of active share as a manager selection tool can lead to poor decisions. Our research illustrates the pitfalls.”
Active share is defined as the percentage of a portfolio that differed from the benchmark index. It is used to determine the degree of active management in an actively managed portfolio.
One of the aims of the paper was to determine the accuracy of previous research on the causal link between higher active share and higher returns, carried out by K. J. Martijn Cremers and Antti Petajisto.
Tidmore, Walker and Kinniry said this earlier research had convinced both investors and financial professionals that “high active-share funds are superior to low-active-share funds”.
However, the trio found the opposite to be true.
They concluded that not only did adjusting the size of an active share ratio have little relationship to gross excess returns, but that on average low cost, low active share funds outperformed the higher active-share options.
The authors said this suggested that the pejorative label ‘closet index funds’ should be reserved for high-cost, low-active-share funds.
Data was taken from a sample of actively managed US open-ended equity funds, including both liquidated and merged funds, from 2003 to 2018. Taking the gross and net monthly returns and annual expense ratios, annual holdings and total net assets under management, the authors of the report calculated the active share per year and compared it with each fund’s Russell style benchmark, rather than assigning the fund to a benchmark that produces the lowest active share (as in Cremers and Petajisto’s 2009 paper). They excluded all sector and specialtist fund categories, index funds and ETFs.
Tidmore, Walker and Kinnniry identified two further ‘urban legends’ about active share.
The first was the notion that diversified stock pickers, previously defined as funds with high active share and low tracking error, significantly outperformed their benchmarks.
However, when the authors looked at funds they defined as high active share and low tracking error over 15 years, they found average underperformance.
The second myth they looked at was the notion that low active share funds were not active enough and inherently led to unsuccessful outcomes for investors.
After separating the low-cost funds from the high-cost ones, the authors found the median low cost, lower active share funds were not only cheaper but had “higher excess returns with lower dispersion and tracking error and lower cost per unit of active share than even low-cost, high active share funds”.
Tidmore, Walker and Kinniry said this indicated the “researcher and practitioner criticism of low-cost, low-active share funds was misplaced”.
This combination, they added, could provide the investor with a significant benefit, by giving them a lower return drag and a lower dispersion of excess returns, “therefore potentially higher expected risk-adjusted returns”.
Overall, the paper came to four major conclusions, the main one being that increasing active share does not lead to outperformance.
Source: Vanguard
“Higher active share leads to a wider dispersion in gross relative performance that is reasonably symmetrical, meaning about an equal chance of increased out- and underperformance, whether the fund is low active share or high active share.”
The next conclusion was a positive relationship between active share and the cost, meaning that as the amount of active share increased, so too did the cost.
This, the authors said, was what caused the “negative relationship between active share and net excess returns”.
Thirdly was that, contrary to prior research, “the low-cost, low active-share strategies that are sometimes dismissed as ‘not active enough’, can in fact be optimal on both a risk-adjusted and non-risk-adjusted basis”.
And finally, was the conclusion that higher active-share funds increase the active risk because of the wider dispersion of the behavioural gap.
“Active share, combined with careful qualitative judgment regarding the health of the investment manager’s firm and the depth of its analytical team, can provide unique information,” added the authors.
“For investors looking to add active share to their fund selection toolkit, we demonstrate that low active-share, low-cost funds are an excellent starting point to help ensure the best chance for investment success not only for the fund itself, but in terms of investor behaviour as well.”