In 2006, two finance professors at the Yale School of Management, Martijn Cremers and Antti Petajisto, began circulating a paper that introduced a new way for investors to evaluate whether mutual funds are earning the high fees they often charge.
Their proposed measurement, Active Share, was widely adopted by the finance industry, quickly becoming one of the most popular ways to measure how different the holdings of portfolios are from their benchmarks. But recent research by Cremers, who now teaches at Notre Dame, suggests that investors should be cautious in how they use it.
The paper, “Active Share and the Three Pillars of Active Management: Skill, Conviction, and Opportunity” published in the Financial Analyst Journal, argues that only portfolio managers who possess certain character traits will be able to outperform benchmark indices.
“The three pillars of skill, conviction and opportunity are applications of the philosophical idea — originating from Plato, Aristotle and Aquinas, for example — that practical wisdom involves the full triad of right knowledge, good judgment and effective practical application,” says Cremers.
To understand how the research progressed from index benchmarking to Plato requires some background.
To start, Active Share is a score assigned to each mutual fund, from zero to 100, based on how much its portfolio weights differ from the fund’s benchmark index — for example, the S&P 500. A portfolio with exactly the same weights as the S&P 500 in the 500 companies that make up this index would have an Active Share of zero, while a portfolio that didn’t overlap at all with the S&P 500 would have an Active Share of 100.
Knowing a mutual fund’s Active Share is critical, because actively managed mutual funds charge higher fees than index funds, which are also known as passive funds. Many investors are willing to pay that premium because they expect the actively managed mutual fund, under the direction of a skilled portfolio manager, to outperform the benchmark.
Unfortunately, many actively managed mutual funds do not do that much stock picking or are even closet benchmark funds, charging high fees for a portfolio that largely mirrors that of the index, says Cremers. Active Share is a tool that investors can use to avoid these closet benchmark funds and find true stock pickers.
Before Active Share, the most common measure of active portfolio management was tracking error volatility, which represented the volatility of the difference in the returns between a fund and its benchmark. But tracking error volatility has a number of flaws. For instance, well-diversified stock picker portfolios may have a lower tracking error than less diversified sector rotator portfolios, even though the later funds may have substantially more overlap with the benchmarks.
In their 2006 paper, Cremers and Petajisto argued that Active Share provided a more relevant view of how much mutual funds differed from the benchmark, and thus of how justified they were in charging a higher fee. Even more tantalizing, their paper found that funds with high Active Share “significantly outperform their benchmarks, both before and after expenses.”
It was this finding in particular that drew the finance world’s attention. Soon, the two scholars were being invited to address groups of investors around the world. In 2007 and 2008, Cremers gave presentations in Rome, Milan, London and Amsterdam. Morningstar, the independent investment research company, adopted Active Share as one of its mutual fund measurements. Cremers and Petajisto’s paper was finally published in 2009 in the Review of Financial Studies, introducing even more people to the idea. “Of all portfolio measures invented over the past decade, Active Share has become by far the most popular,” Morningstar analyst John Rekenthaler wrote in 2014.
Active Share was quickly embraced by both academics and investors as an important new tool to evaluate portfolio managers. But some investment analysts cast doubt on the usefulness of Active Share by itself as a way to predict future performance. In 2014, Fidelity released a paper arguing that “investors should be wary of trying to make precise distinctions about manager skill or return potential using Active Share alone.”
In response to these criticisms, Cremers, who recently was named the Bernard J. Hank Professor of Finance at Mendoza College of Business, began writing a series of papers clarifying and refining his original findings.
In 2016, he and Ankur Pareek of the Rutgers Business School published a paper in the Journal of Financial Economics showing that, among high Active Share portfolios, only those with “patient” investment strategies — those with stock holding durations of over two years — were able to outperform their benchmarks. Cremers saw this as a way to correct a common misunderstanding about Active Share — one he admits his original paper introducing Active Share may have inadvertently encouraged.
“Some people seem to think that high Active Share means the manager has skill, and that the fund will outperform,” he explained. “Active Share doesn’t measure performance. It doesn’t measure skill. It just measures how different the fund is from the relevant index fund. I think we may have contributed to this notion ourselves, because we chose the subtitle, ‘A New Measure that Predicts Performance,’ for our 2009 paper. If I were writing it today, I would probably choose a humbler subtitle.”