Earlier this year, the New York attorney general’s office reached an agreement with 13 mutual fund companies to publicly disclose their funds’ Active Share measures; the news has given new weight to this metric. However, advisors and other parties, including investors, marketers and regulators, should be wary of placing undue importance on Active Share out of context.
Active Share is a simple measure revealing how much an equity portfolio’s holdings differ from its benchmark index. An index portfolio will have an Active Share near zero, while a highly active one may score close to 100 percent.
Despite (or perhaps because of) its simplicity, Active Share can be easy to misunderstand and misuse.
Active Share is perceived to be a tool for finding “good” managers (typically interpreted as the more active, the better). Yet this interpretation ignores two very important questions. Do all capable active managers always have high Active Share? And what do we mean by “high” in this context?
High Active Share and good portfolio management are not necessarily synonymous. The Active Share of a capable active manager, especially one that ignores index weights, should be expected to vary over time. Occasionally, the portfolio may be closer to index weights for valid investment reasons, resulting in low Active Share.
Admittedly, an active manager who always “hugs” the index may not be a good choice, but an occasionally low Active Share is perfectly consistent with a capable manager. The notion that high Active Share implies outperformance is wrong. It indicates only that a portfolio is significantly different from its benchmark, and financial advisors and investors will typically need to dig deeper to determine a manager’s capability. An Active Share greater than zero is a necessary but not sufficient condition for benchmark outperformance over time. In fact, there is no guarantee that a portfolio with high Active Share won’t underperform its benchmark.
With regard to defining “high,” most Active Share research has focused on U.S. large cap equity portfolios. Our research showed that the median Active Share of portfolios benchmarked to the S&P 500 was 72. So, if we had to provide a range for Active Share, we could say that over 80 is high and under 60 is low. But (and this is really important) assumptions on high and low can change drastically for portfolios benchmarked to other than U.S. large cap indices. For example, our research also showed the average Active Share for global all-cap portfolios is 89; for an Australian large cap portfolio, it’s under 50. High (or low) for Active Share is NOT an absolute; it depends heavily on the index being used. The more stocks in an index, the higher the likely Active Share of portfolios benchmarked to that index, and vice versa. Using the wrong index or comparing portfolios with different benchmarks may yield a misleading Active Share result.
Without a frame of reference, saying Active Share is high is like trying to determine if someone is overweight, knowing only their weight but not their gender, height or age. If a portfolio’s Active Share is 70, is that high, low or average? We simply don’t know without more information.
Some U.S. and international regulators are now taking aim at managers who charge fees for active management on portfolios with low Active Share, implying that investors are not getting value for money. The concept has some logic but the problem is in how the regulators seek to apply it. We believe using a single absolute number to determine whether a portfolio’s Active Share is high enough to warrant a certain fee is wrong. And making managers state Active Share without providing a benchmark context may mislead. It would be a mistake to include portfolios with different indices in the same peer group. Currently, our evidence shows only a low correlation between active managers’ fees and their Active Share; with more transparency this may change over time.