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When is active management really active? Martijn Cremers is a professor of Finance at the University of Notre Dame in the United States, where he teaches courses on investments and corporate governance to MBA and undergraduate students. In a research paper* published in 2009, he introduced a measure of active management called ‘active share’, which compares the holdings of a fund with those of its benchmark. This concept has come into widespread use across the financial industry. We talked to him about the rise of passive investment strategies and how active share can be used to select investment funds.
What is your view on the rapid expansion of passive strategies?
“It represents a major shift in how people invest in funds and is a serious disruption for active managers. However, it is also important to put it in perspective. In a recent research paper** of U.S. mutual funds, we showed that the rise of passive investments happened largely at the expense of ‘closet index funds’. These funds have a relatively low active share, below 60%, but are still marketed as actively managed, and as a group, they consist of far fewer assets now. However, we have not seen any increase in the presence of funds with high active share, say above 80%, since 2000.”
How have active managers reacted?
“A paper we just published*** looks at the relationship between indexing and active management in over 30 international mutual fund markets. Active managers have reacted by lowering their fees and becoming more active, as measured by their level of active share. Further, we find some evidence that active stock pickers’ success rate increases when indexing becomes more prevalent. This could be due to an increase in the number of stock-picking opportunities in markets with fewer active managers, or perhaps stock pickers work harder in a more competitive environment.”
What should investors take into account when analyzing a fund’s degree of activeness?
“The two basic measures of activeness – the difference between fund and benchmark – are tracking error (difference in returns) and active share (difference in holdings). Both are useful tools, but only as part of a larger toolkit. Regarding active share, investors should compare the fees with the level of active share. A simple way is to compute the ‘active fee’, which equals the expense ratio divided by the active share. Active share also depends on the style and the investment universe. For example, roughly speaking, active share is considered high for large cap funds when it is at least 80% and for small cap funds, at least 90%. Finally, active share is only useful if you are using the right benchmark for the fund.”
Many high active share funds argue that your research ‘proves’ that they are the best funds out there. How effective is your active share measure for identifying funds that are likely to outperform?
“Our academic research does not prove anything regarding any particular fund or any particular group of funds, as it is based on fairly long periods of time and large samples of funds. Instead, our research is conceptual, and hopefully provides interesting concepts and tools to better understand what investment managers are doing and on that basis, what outcomes are expected. Moreover, our research suggests that it is easier to predict average future underperformance of certain groups of funds (low active share and more expensive) than future outperformance of other groups of funds. One important conclusion is that investors should avoid funds with low active share that charge high fees.”
Active share is only a starting point in the fund selection process
How would you go about selecting active funds? How much weight would you give to active share in that process?
“There are three things active managers need in order to be successful: skill, conviction and opportunities. A high level of active share means that the manager’s stock-picking skills are applied to a high proportion of assets in the portfolio, with conviction, and that there are sufficient investment opportunities. Active share does not measure the manager’s actual skill, it only measures how much stock picking the manager does. Therefore, it is only a starting point. I think that there needs to be some friction, some difficulty associated with the manager’s investment approach, for him to sustain success in the long term. For example, in another recent paper**** , we consider a patient investment approach with high active share. We found that most high active share managers are not very patient, and most patient capital isn’t very active. Patience and high active share is a rare combination, probably because it is hard to be patient in a generally impatient world. We found that among high active share managers, patient funds had the strongest outperformance, consistent with the ‘limited arbitrage’ argument of Shleifer and Vishny.”
This article was initially published in our Quant Quarterly magazine.
* Cremers and Petajisto, “How active is your fund manager? A new measure that predicts performance,” 2009, Review of Financial Studies 22(9), 3329-3365 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=891719
** Cremers, “Active Share and the Three Pillars of Active Management: Skill, Conviction and Opportunity”, forthcoming in the Financial Analysts Journal https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2860356
*** Cremers, Ferreira, Matos and Starks, “Indexing and Active Fund Management: International Evidence”, 2016, Journal of Financial Economics 120(3), 539-560 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2558724
**** Cremers and Pareek, “Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently”, 2016, Journal of Financial Economics 122, 288-306 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2498743