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This Signal Showed Promise in Identifying Top Active Managers. But the Results Have Been Disappointing.

Instead of choosing concentrated or best ideas funds — those with high active share — asset owners would have been better off doing the opposite.

Over the last decade, allocators, consultants, and asset managers have adopted active share, which measures how similar a portfolio is to an appropriate index, as a critical part of their search for the best actively managed funds. The high active share boosters had good reason to use the measure, which ostensibly identifies best ideas funds or managers with the highest conviction in their picks. That’s because a landmark study in 2009 laid out the case for how these funds had a higher potential of outperforming than peers who closely resembled their benchmarks. 

But a recent Morningstar study of fund performance between 2003 and 2020 paints a different, and in some cases, more nuanced picture. In the end, Morningstar argues that those who invest in funds with relatively low active share have been better off. That’s the exact opposite of what investors and others have come to believe. Morningstar evaluated funds across its nine investing style boxes from January 1, 2003 to December 31, 2020. The Chicago research firm found that large-cap value, large-cap blend and large-cap growth funds — with high active share — “demonstrated the most significant before-fee performance advantage over respective peers with low active shares.” However, after fees their advantage was significantly diminished. What’s more, in every category, these funds were shown to have higher risk than their peers with lower active share scores.

Things got worse for high active share funds when Morningstar looked at the time period between 2011 and 2020. “Funds with high active share significantly underperformed those with low active share in four categories, both before and net of fees. High-active-share funds failed to deliver superior net-of-fee results in any category,” according to the study. 

It’s not surprising that the measure identified in the academic literature would disappoint in real life. Investors and managers are always searching for the infallible measure or model. With active share, asset managers used the metric to design new products and evaluate existing funds and investors turned to it to justify their use of high cost active managers when index funds have been available for pennies. And the 2009 research by Martijn Cremers and Antti Petajisto was a robust one, examining the performance of domestic equity mutual funds from 1980 to 2003. Michael Ervolini, founder and CEO of Cabot Investment Technology, which is owned by FactSet, is skeptical about using any statistic in isolation. Cabot, a student of behavioral finance, told Institutional Investor that the underlying factor that affects portfolios’ performance is managers’ skills. “It’s a bad idea to pick managers based solely on active share, because it doesn’t indicate any skill at all,” Ervolini said. “It’s like picking a baseball player based on the color of the uniform.” 

The Morningstar study argues that some of the different results come from a misunderstanding of the measure within certain investing styles. For example, large-cap growth benchmarks are highly concentrated in a handful of stocks like Microsoft and Apple. Active share of the peer group tends to fall as concentration increases. Indeed, Morningstar found that the median active share was 60 percent in the large growth category, compared to 94 percent in small-cap and mid-cap blend. 

“Proper active-share comparisons across categories are thus more difficult than the simple use of absolute measures often suggests,” according to the study. In an interview, Robby Greengold, author of the report, added, “If [investors] are going to be applying active share, they need to apply it in the proper context.”

Even in categories where high active share funds show an advantage, fees cut into that. 

“Funds with relatively high active share cost 20 to 50 basis points more than those with low active share within the same category, as of year-end 2020, a steep price given high-active-share funds’ lackluster results since January 2003,” according to the study. 

But Morningstar said the measure still has value. Greengold stressed that active share can be used to identify risk levels because high-active-share funds have a positive correlation with volatility, tracking error, and concentration in the biggest stocks. It can also help identify funds that look too much like their benchmarks, but it shouldn’t be applied as a screening tool.

“I would suggest investors should not be ranking funds on their active share, assuming that higher is better, because there’s not much evidence to show that is the case,” he added.

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