In the old days, there was one investment strategy: Pick the winners, avoid the losers, and pocket the difference. The details varied from manager to manager, but virtually every portfolio was built around this simple creed. Starting in the 1960s, however, this monopoly on strategy began to crack with the rise of a competing ideology that rejected skillful security selection in favor of middling results.

By the 1970s, the first portfolios that systematically targeted average returns arrived. In the four decades since, indexing has grown from an experiment into a mainstream industry with trillions of dollars under management. But after nearly half a century of theoretical and commercial triumph with the ascendancy of passive investing, is the pendulum of financial history swaying back to active management?

In dollar terms, active management never really gave up its crown as investing's leading ideology. Most of the assets on planet Earth are still actively managed, even though indexing has grabbed substantial share over the years. Yet the intellectual debate has increasingly favored indexing over the years, which has been no small marketing advantage for that sector of the industry's expansion. But active management is being revisited and reinterpreted by academics and practitioners in the 21st century. Is that a sign that indexing's commercial momentum is set to slow or perhaps reverse?

At issue is the growing body of research in recent years that contradicts earlier studies that cast aspersions on the economic logic of active management. A new breed of analysis argues that efforts at adding value over a benchmark aren't hopeless after all. Even more provocative is the bold claim that it's possible to identify managers with the skills to beat the market in the future.

For veterans of the long-running debate on passive versus active investing, this sounds like a been-there-done-that moment. Supporters of active management are forever claiming the wisdom of their beliefs. Meanwhile, indexers never tire of reminding us that the evidence is thin in favor of skilled managers consistently churning out excess returns over a relevant benchmark-alpha in the lexicon of financial economics.

The smoking gun for indexers is the simple fact that alpha invariably sums to zero, a financial fate that ensures that the pursuit of benchmark-beating performance is eventually offset by losses. No one disputes the point, at least when it comes to money management writ large. Elaborating on this mathematical destiny has been a staple in the literature since Michael Jensen's influential 1968 Journal of Finance paper-"The Performance of Mutual Funds in the Period 1945-1964"-demonstrated that negative alpha was typical for the average active manager after adjusting returns for trading costs and expenses.

Countless researchers over the years have corroborated Jensen's basic message. Yet the broad-minded methodology behind these studies masks a deeper truth, according to a new generation of studies. The older papers emphasized an expansive definition of managers intent on beating the market. The problem is that searching for investment skill requires a lighter analytical touch to separate the wheat from the chaff. Some analysts argue that they've satisfied this higher standard of evaluation by developing new tools that can spot alpha-generating talent. The result, they claim, is that investing talent isn't as fleeting as we've been told.

Searching For Alpha (And Finding It)
Picking winners and avoiding losers isn't easy, but it no longer looks impractical, according to dozens of studies from the past decade. Granted, the future is still uncertain. That fact alone goes a long way in explaining why beating the market is so tough and indexing remains competitive. But the odds of finding manager skill isn't nearly so formidable as earlier research suggests.

Among the converts to this revised view of alpha is C. Thomas Howard, a finance professor at the University of Denver and principal at AthenaInvest, a research consultancy and money management firm. He was once a skeptic of active management, but Howard has switched his allegiance. He recently told Financial Advisor that there's "considerable recent research support" for his updated view of money management. "There are several studies that say it's fairly easy to identify winners."

Howard's firm lists dozens of research papers on its Web site (athenainvest.com) from various authors that back up the idea that recognizing skill is more than a wide-eyed dream of optimists. The inventory of supporting material includes a recent study that is perhaps the leading document in what some are calling a 21st century renaissance for arguing in favor of active management: "How Active Is Your Fund Manager? A New Measure That Predicts Performance," published in the September 2009 issue of The Review of Financial Studies.

The paper introduces a simple, intuitive metric for assessing a manager's potential for earning excess returns over his benchmark by quantifying a portfolio's so-called "active share." This is defined as the portion of assets that differ from the target index. The degree of divergence holds clues for predicting alpha, report the authors-Yale finance professors K. J. Martijn Cremers and Antti Petajisto.

The paper can be thought of as a refinement of tracking error, which has been used for years for evaluating investment strategies. Tracking error calculates how closely a portfolio follows its benchmark (or not) by measuring the volatility (standard deviation) of the difference between the returns of a fund and its benchmark. But tracking error does a poor job of distinguishing between the two main types of active management: individual security selection and factor timing, such as industry-rotation or market-timing strategies.

A superior metric for judging active management's results is comparing a portfolio's holdings to an appropriate benchmark, according to Cremers and Petajisto. Their active share measure quantifies the divergence in a fund's securities versus an appropriate index. The readings range from 0% (no deviation in holdings and weightings versus an index) to an active share rating of 100% (zero overlap with the index). The closer to 100, the stronger the degree of active management and (the authors emphasize) the higher the odds of delivering alpha.

It's an idea that's been informally discussed for years in active management circles. If there's any chance of beating an index, the portfolio must differ from the benchmark in a meaningful way. That alone is no silver bullet, although the reasoning is bound up with the recognition that a manager who's willing to make more than trivial bets harbors above-average confidence in those choices. Think Warren Buffett or George Soros, for instance. No wonder that concentrated-portfolio strategies-holding only the "best picks"-resonate strongly within the active management community.

Measuring a portfolio's degree of active focus is one thing, but does it offer any practical insight for choosing managers? Yes, Cremers and Petajisto report. Active share "predicts fund performance" because "funds with the highest active share significantly outperform their benchmarks, both before and after expenses," they write. In fact, the evidence is strong enough to convince Morningstar to offer active share rankings through an Excel plug-in feature for its institutional research platform, Morningstar Direct.

If active share helps identify skill, it's no less useful for outing those managers that go a bit too far in cozying up to their benchmarks-closet indexers, as they're known. "It makes intuitive sense that most fund managers are skill-less and at some level know it and hug the indexes," notes financial planner and author William Bernstein. "The really good ones are willing to make real bets."

Active share would be far less convincing if the study were a loner. But Cremers and Petajisto's analysis echoes dozens of reports in recent years that collectively lay the groundwork for expecting: 1) a small subset of talented managers that can earn excess returns over time, and 2) alpha that is partly predictable.

Analyzing the "best ideas" of active equity mutual fund managers, for example, "presents powerful evidence that the typical mutual fund managers can, indeed, pick stocks," according to another recent study. "The poor overall performance of mutual fund managers in the past is not due to a lack of stock-picking ability, but rather to institutional factors that encourage them to overdiversify, i.e. pick more stocks than their best alpha-generating ideas," report Randy Cohen of Harvard and two co-authors in "Best Ideas," a working paper.

Another study discourages the idea that positive alpha is due solely to luck. Evaluating nearly 30 years of mutual fund history, a 2006 Journal of Finance article finds that a "sizable minority of managers pick stocks well enough to more than cover their costs" and that alpha "persists." ("Can Mutual Fund 'Stars' Really Pick Stocks? New Evidence from a Boostrap Analysis," by Robert Kosowski, et al.)

These papers are hardly outliers, according to a survey of the literature in the niche. Dozens of studies from the past decade show that while the average active manager doesn't outperform, "a significant minority of active managers do add value," according to "Active Management in Mostly Efficient Markets" by Robert Jones (a co-founder of Goldman Sachs' quantitative equity fund division) and Russ Wermers (a finance professor at the University of Maryland).

Don't Give Up On Indexing Yet
Alpha, it seems, isn't as random as earlier research suggests. Recognizing that investment skill exists and that it's possible to recognize it in advance is surely valuable information. Yet it's hardly a death knell for indexing. Yes, proponents of active management can now cite a wide assortment of studies for intellectual aid and comfort. That's a big change from surveying the state of active management in, say, 1995. But the challenge is translating the updated empirical factbook on alpha into superior risk-adjusted excess returns on a sustained basis relative to a comparable strategy using index funds.

That's a hurdle that inspires keeping expectations in check. To understand why, let's take a closer look at the active share ranking with real world money management. We can start by recognizing that while active share encourages the search for alpha, the odds of success still fall well short of proving that picking winners is easy, much less guaranteed. What's needed is a study (or ten) that objectively evaluates the performance of using Cremers and Petajisto's metric with actual money over a period of years. That, of course, will take time. Meanwhile, we can only consider the possibilities, and the possible pitfalls. Not surprisingly, the road to alpha salvation still has a few bumps.

Let's assume that portfolios that depart from a benchmark have a stronger chance of earning higher returns. But the same reasoning suggests that the odds of suffering negative alpha are also elevated. It's not enough to simply hold the top-ranked active share fund for a given strategy. Prudence suggests buying several top-tier funds to limit damage from any managers who bet big and lose. Yet diversifying across managers is a solution that can minimize, if not eliminate, the active share edge. If you choose five managers that rank high on the active share scale and two of them end up with mediocre records, middling performance may be the result overall for the five-manager allocation. The risk of suffering a high-priced index fund, it seems, is quite real.

There's another potential stumbling block with turning active share's encouraging paper results into the real deal. As Cremers and Petajisto's study notes, most of the reported alpha linked with high active share is concentrated in funds with modest assets under management.

Figure 1 illustrates how active share alphas compare with fund size. Note that alphas are substantially higher overall for funds in the top quintile of the active share ranking (red bars). But it's also clear that the alpha fades with larger funds. For instance, funds in the highest active share quintile that are also in the smallest portfolio size quintile (the red bar on the left side of the chart) earned an average alpha of 1.71% a year for 1990-2003. At the opposite extreme, funds in the largest size quintile that were also ranked in the highest active share quintile (the red bar on the extreme right) suffered negative alpha of 0.7% a year. That's better than lesser active share-ranked funds, but it's still negative alpha.

Why is positive alpha associated with high active share rankings in smaller funds? Bernstein sees at least two explanations. One is that the alpha-picking power of active share is an illusion born of survivorship bias. If not, then identifying manager talent washes out as assets under management rise. "Either way, [active share] is not something I would find terribly useful," he says, despite the fact that he thinks the paper represents "important work."

Even if you think active share can help you pick managers, there's the problem of crunching the numbers on a timely basis. The formula outlined by Cremers and Petajisto is simple enough to calculate in Excel. The stumbling block is the obligatory dose of fresh data on a fund's holdings. In fact, you'll need recent data on lots of funds. A sensible use of active share rankings as a screening tool inspires sifting through a broad list of portfolios within a strategy. Imagine that you're searching for strong managers in the small-cap domestic-equity blend mutual fund category. According to Morningstar Principia, nearly 200 actively managed products are available. Assuming there are 50 to 100 holdings per fund, an intensive round of statistical analysis awaits.

Even if you overcome this hurdle, don't get too comfortable. There will be ongoing maintenance. If active share shines brightest in smaller funds, you should plan on bailing out of products that grow too large. In turn, you must redeploy the proceeds into smaller portfolios that rank high on alpha-generating prospects. In other words, you'll need to run active share evaluations regularly.

Alternatively, you could tap into Morningstar's Excel plug-in tool, which shoulders the number-crunching burden. That's a practical solution that saves you from the tedious analysis, but the pricey cost of subscribing to the institutional Morningstar Direct platform will deter most financial planners.

A more cost-effective substitute is using the R squared (R2) metric, which can be thought of as a poor man's active share ranking. R2 measures the degree that a fund's movements are explained by its benchmark. The possibilities range from zero (the index has no relevance for the portfolio) to 100, which indicates that a fund's movements are virtually identical to the index's.

A recent study shows that R2 is a useful predictor of future fund performance ("Mutual Fund's R2 as Predictor of Performance," a working paper by Yakov Amihud and Ruslan Goyenko). The basic idea is that a fund with a relatively low R2 versus an appropriate benchmark is likely to be more active and therefore more likely to deliver alpha. Samuel Lee, a Morningstar analyst, agrees. "Active share correlates closely to the best-fit R2," he says. An R2 near 100 is probably a closet indexer, while a reading of, say, 70 is probably a sign of robust active management.

It doesn't hurt that calculating R2 is much easier compared with active share. All that's needed for R2: return data for the fund and its benchmark. Dump the numbers into Excel and with the push of a button you're done. Even that minimal effort is unnecessary, since you can find timely R2 updates on funds for free at Morningstar.com.

Unfortunately, there are limits to R2's powers, warns Petajisto. "It's a blunt tool," he advises in a recent interview. R2, like tracking error, has a hard time distinguishing between the two main types of active management: factor bets (e.g., market timing) and security selection. The distinction for evaluating active portfolios was first outlined almost 40 years ago by professor Eugene Fama ("Components of Investment Performance," Journal of Finance, June 1972). It remains a key issue to consider because predicting alpha via security selection is reportedly more reliable compared with trying to forecast excess return via factor bets. Therein lies a key rationale for using active share, says Petajisto.

The More Things Change...
Petajisto isn't shy about singing the praises about active share, but he also recommends it as part of a broader evaluation process. He sees it as helpful for narrowing the field of potential active managers down to a short list worthy of closer review. It's one of several tools in the toolbox, he emphasizes.

Even a world where it's possible to develop a high (or at least higher) level of confidence for predicting alpha doesn't diminish the value proposition of indexing, he adds. "I still see the trend toward indexing as reasonable," Petajisto says. "It's an easy choice because you don't have to evaluate managers or compute active share." Finding alpha may be easier than conventional wisdom suggested a few years ago, but you must be willing and able to work harder to reap the rewards.

That's no reflection on the power and ease of tapping low-cost betas to finance an investment strategy. Adjusted for the effort involved, indexing is still compelling and arguably preferable for most investors, particularly in a multi-asset-class framework. The odds of hitting pay dirt with active managers may be higher than we thought. But it's not clear that the odds of success are equally higher in pursuing alpha across the full spectrum of a broad asset allocation plan over many years. After all, you need a fairly high rate of success in pursuing alpha to offset the higher costs. By contrast, the low-cost approach of indexing offers more confidence for capturing average returns. That means you can spend more time on what is arguably a more critical variable: managing the betas (i.e., asset allocation).

In sum, the bias toward average performance in the long run remains a powerful force to consider if you're managing a diversified strategy with several asset classes. Alpha may be partly predictable and persistent, but someone is still destined to suffer negative alpha. Active share analysis doesn't change that calculus, although it may help improve the odds that you and your clients end up on the sunny side of the equation.