This In Practice piece gives a practitioner’s perspective on the article “Active Share and the Three Pillars of Active Management: Skill, Conviction, and Opportunity,” by Martijn Cremers, published in the Second Quarter 2017 issue of the Financial Analysts Journal.
What’s the Investment Issue?
Does Active Share predict outperformance? Active Share is not a measure of a manager’s skill but, rather, a mathematical measure of the percentage of the holdings in a fund that are different from the holdings of the fund’s benchmark. In recent years, investors have begun to use this tool to assess whether fund managers with high Active Share produce superior returns.
The study offers investors potentially valuable insight into which active funds to select. It addresses whether Active Share can help identify closet trackers, it helps investors avoid underperformance by identifying funds with low Active Share and high expenses, and it is useful for picking funds with high Active Share.How Does the Author Tackle the Issue?
The author’s premise is that Active Share is not in itself a predictor of outperformance. So, he investigates to what extent returns result from Active Share alone and to what extent they result from skill, conviction, and opportunity—a three-pillar framework he suggests investors should use to evaluate the performance of actively managed funds.
The author tests each of these three pillars of investment performance in portfolios with differing levels of Active Share.
The study first investigates the relationship between high Active Share and the cost of skill. It proposes the concept of an “Active Fee” as a better measure of the cost of active stock picking, or skill. Active Fee, introduced by the author in another paper in 2016, is a formula that investors can use to pay only low index fund fees for portfolio positions that overlap with the index benchmark. The non-overlapping holdings must outperform the index fee minus the Active Fee if investors are to benefit by investing in the active fund rather than the index. So, Active Fee is, in effect, the hurdle rate a portfolio’s Active Share must get over to “earn its keep” versus the portfolio’s benchmark.
The Active Fee formula expresses Active Share as 100% minus the sum of the overlapping weights between the portfolio and its benchmark. As an example, if the fund and its benchmark have an identical weight of 5% in Apple stock, then the performance of Apple is disregarded in the performance of the active strategy.
Second, the author examines the effect of manager conviction by analysing fund holding durations. He chooses duration as a proxy for investment conviction on the basis that long holding period strategies require stronger conviction because they are riskier for the manager to pursue and harder to replicate. The increased risk is created by the possibility that a long-term profitable strategy may underperform in the short term and cause investors to redeem their fund shares.
Third, the author considers opportunity, examining whether some investment styles, such as small-cap strategies, offer greater active stock-picking opportunities than others, such as large-cap strategies, and whether this distinction leads to higher fund performance.What Are the Findings?
First, low Active Share funds with high expenses underperform strongly against their relevant benchmark index. There is no negative relationship between performance and expense ratios for high Active Share funds.
Second, among high Active Share funds, only those with long holding durations outperform on average, whereas funds with rapid turnover underperform. In other words, only active stock pickers with strong, long-term convictions are successful. To quantify this finding, the study found that in portfolios where both Active Share and holding durations are in the top quartile, alpha (return above the benchmark) is 1.94% a year. By contrast, in portfolios where Active Share is in the top quartile but holding duration is in the bottom quartile, alpha is –1.15% a year.
Third, small-cap funds tend to have higher Active Share than large-cap funds, which suggests that small-cap managers have better stock-picking opportunities. The ability to outperform with patient, high Active Share strategies is similar for both small-cap and large-cap fund managers.What Are the Implications for Investors and Investment Professionals?
Because there is no evidence that high Active Share funds underperform on average over the long term, investors interested in stock-picking strategies could use high Active Share as part of their fund selection process. It is probable that investors do not currently do so. Because of many mutual fund investors’ lack of experience or knowledge, the market for low Active Share funds may be uncompetitive. This allows low Active Share funds to overcharge, meaning investors receive substantially less value than they may believe.
Investors could further narrow their search for better-performing active fund managers by allocating to high Active Share managers that have strategies that are difficult to implement. The difficulty of implementation limits the amount of arbitrage capital that will pursue even highly attractive investment opportunities.
Finally, because low Active Share funds with high expenses underperform, investors in funds with low Active Share should carefully monitor the fees they pay. To that end, the author proposes using Active Fee, described earlier, to measure the costs of active stock picking.