The Myths and Misunderstandings Behind Active Share
Updated: May 17, 2022
The issue of closet tracker funds charging high fees for poor performance has been a recent gripe of the Financial Conduct Authority. It is a primary concern for them as they seek fairer outcomes for investors, with the intention of forcing these funds to make it clearer that they are in some way constrained. This is in line with the industry's recent embrace of active share as a crucial tool for identifying genuinely actively managed portfolios. However, while much has been written about active share, it is still in many respects a misunderstood measure.
"Active management is simply not a game that everyone can win"
The principle behind active share is to measure the difference between a fund and the benchmark index it is seeking to beat. However, difference can be measured in various ways. If an actively managed fund is identical to its benchmark in terms of holdings and weights, it cannot, by definition, beat it.
This is not opinion, but a mathematical truism - in fact, if the fund is charging fees, it will underperform it (assuming the manager is not being charitable, which seems a fair assumption). So, for a fund to have any chance of beating its benchmark, it must be different to it; if a fund is only slightly different, the chances of it beating its benchmark net of fees are still practically zero.
Again, fact, not opinion. In other words, the more different a fund is to its benchmark the greater the potential for it to beat its benchmark after costs. Whether it will or not is a different matter; at this stage we are just talking about potential. One measure of the difference between a fund and its benchmark that has been around for decades is tracking error, which measures the differences in returns. However, tracking error has always been used as a risk measure, and therefore something investors should limit rather than seek out This maybe one reason why the use of active share is not as widespread as it should be.
Maximising active share and minimising tracking error at the same time must be wrong, surely, if conceptually they both measure difference. The answer is to think of tracking error both as something one does not want too much of, but at the same time not too little of either. The next misunderstanding relates to the fact there are different versions of active share. The one that has grabbed the headlines in recent years was coined by Martijn Cremers and Antti Petajisto in a 2006 paper, How Active is your Fund Manager? Their calculation sums the absolute differences between fund weight and benchmark weight for each holding, then divides by two to give a scale of 0% to 100% -a passive fund that naturally mirrors its benchmark has an active share of zero.
However, in 2005, a year before Cremers and Petajisto introduced their version, Ross Miller wrote a paper entitled Measuring the True Cost of Active Management, in which he introduced his version. Miller's is more complicated than the later version, but it uses some intermediate maths to derive the precise portion of any fund that does not correlate with its benchmark - the active share - leaving the part that correlates 100%, the passive share.
While Cremers and Petajisto used their version to demonstrate that, in general, the higher the active share, the better the fund performance, Miller was seeking to show how many US mutual funds were sneakily charging exorbitant fees. In the case of one fund that shall remain nameless - and hopefully by now asset-less – the active expense ratio was 23%.
A third misunderstanding is that active share is portrayed as an easy way to identify outperforming funds. High active share, whichever version, or high tracking error cannot by themselves identify outperforming funds – it could never be that easy. They merely provide an objective measure of the potential of a fund to outperform its benchmark.
You certainly would not want to buy a fund that had no potential to outperform, but it is merely the first, and easier, step. The second step is to evaluate the fund manager's investment style and process, a much harder task by dint of it being far more subjective. In reality, the better fund managers – those with effective investment styles and processes - understand that it is important, necessary even, to be different, and so the two tend to go hand in hand. However, they should be considered separately.
Perhaps the final point to make is that criticism of the active management industry is always framed in the media and by the passive fund industry in terms of the percentage of funds, frequently high, that underperform their benchmark. Active management is simply not a game that everyone can win, in the same way that we cannot all be above average in bed. The answer is not to outlaw active management, as some have suggested, but to give investors more tools to evaluate funds.
Published in Investment Week
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.