We could be asking the wrong questions about active versus passive management, a researcher says.
While most active funds fail to outperform their benchmark indexes over the long term, research from Martijn Cremers, the Bernard J. Hank professor of finance at the University of Notre Dame, has found that the more actively managed a mutual fund, the more likely it is to outperform.
“If you buy an active product, you pay a much higher fee, so you want to make sure that the active product is actually different from the passive products out there,” Cremers says. “If the difference in holdings is not very substantial, it’s unlikely that the fund is going to deliver value for investors, particularly if the fund is not very cheap.”
A recent paper, “Active Share and the Three Pillars of Active Management,” reinforces Cremers’ previous findings on “active share,” a quantitative measure of what percentage of a fund’s portfolio deviates from its benchmark.
A fund with a zero percent active share would precisely replicate its benchmark, while a fund with 100 percent active share would have no overlapping holdings with its benchmark at all.
“A low active share for a large-cap fund is 68 to 70 percent,” Cremers says. “Twenty to 30 percent of large-cap funds have active share that low.”
Low active share products are an indicator of “closet indexing”–portfolio managers who claim to add value but tend not to deviate from their benchmarks.
Cremers studied U.S. retail mutual funds with at least $10 million AUM from 1990 to 2015. During that period, the percentage of assets in funds with active share less than 60 percent peaked during the dot-com collapse at the end of the 1990s and the 2008 global financial crisis, yet has declined steadily since.
“What that really tells you is that the funds that have low active share have lost assets more so than individual funds increasing or decreasing active share,” Cremers says. “Active share at the fund level tends to be very sticky, consistent over time for a particular manager.”
In the same 25-year time period, only funds with the highest quintile of active shares outperformed benchmark indexes, according to Cremers.