As the equity bull market rolled along in the 1980s the argument began that passive indexes outperformed active managers at a lower cost began to take hold. As the bull equity market moved along it was also observed that many so-called active managers were simply “closet indexes.”
This caused a series of questions to arise in the investment universe. One, was “Is there any value in active management?” and more importantly, “Is my active manager simply a closet index charging higher fees for providing what a much cheaper index could provide and simply shifting a few stocks picks to justify the fees?”
The questions shifted from “should you invest in active or passive” to “what defines an active manager.”
In March 2009 K. J. Martijn Cremers and Antti Petajistoy from the International Center for Finance Yale School of Management introduced a measure that sought to answer those question. In a paper titled “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” Cremers and Petajisoy introduced “Active Share.”
Here is how they described it: Active Share represents the share of portfolio holdings that differ from the benchmark index holdings. We compute Active Share for domestic equity mutual funds from 1980 to 2003. We relate Active Share to fund characteristics such as size, expenses and turnover in the cross-section and we also examine its evolution over time.
The paper went on to present research that showed that Active Share predicts fund performance. “Funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence. Non-index funds with the lowest Active Share underperform their benchmarks.”
In “Taking a Look at Active Share,” a 2013 research paper produced by Lazard Asset Management, authors Erianna Khusainova and Juan Mier conclude, “Rooted in the assertion that the only way to outperform a benchmark is to be different from it, active share captures this idea in a concise measure by comparing portfolio holdings, and their size, to benchmark holdings. Simple, intuitive, and persistent over time, active share introduces another dimension in the evaluation of active management previously not captured by the traditional, historical returns-based measure—tracking error.”
In follow-up research Cremers and Petajistoy state, “Managers with an 80% active share have earned net excess returns of 1.00% higher than managers with an active share of 50%,” according to a report from John Gabriel of Weitz Funds.
However, others have questioned Active Share’s ability to predict outperformance.
A 2014 report by Fidelity noted, “While active share may help investors compare active managers, it may not be a consistent measure across different market-cap size mandates and benchmarks. Although often-cited research has suggested that active share is positively correlated with excess return…higher levels of active share come with greater levels of return dispersion, and higher downside risks.”
An April 2015 AQR Paper titled “Deactivating Active Share”, noted that “Active Share may not be useful for predicting outperformance,” and states, “Our conclusions do not support an emphasis on Active Share as a tool for selecting managers or as an appropriate guideline for institutional portfolios.”
Active Share is based on a simple premise, which is that for a fund to be truly active, it must look different and have different components than the components in the benchmark. Claims that it predicts strong outperformance is a tougher sell, but what it does show is that a high Active Share manager is doing his own work. Whether that a high Active Share means a manager will outperform a benchmark is open to debate.
Based on its simplicity, Active Share proves that you are getting what you paid for, as long as you define that as an active management approach that is not leaning on a benchmark to select funds. In selecting an active investment you may need to do additional qualitative research than just finding a fund with a high Active Share.