Active share is a measure that has been used in the investment industry for awhile, but since the discussion of actively managed funds that are so-called index huggers is on the rise, this measure has become very popular. But, does active share truly help identify active funds?
What is active share?
Active share is the usual method for comparing the performance of a fund with its benchmark to find differences in the risk/return profile of the pair. But these ratios don’t tell the full story, since they do not look at the portfolio holdings. Instead, active share measures the percentage of the fund’s holdings that differs from the constituents of its benchmark/index, either by name or percentage of the weighting in the portfolio versus the benchmark. A higher active share is seen as being better, since research shows that funds with a higher active share are more likely to outperform their benchmarks. These findings are one of the reasons active share has become so popular, but from my point of view it has been overlooked that the numbers are averages, meaning there are also funds with a high active share that underperform their benchmark. Active share doesn’t tell anything about the quality of the active decisions made by the portfolio manager.
Pitfalls of the active share
Even though it sounds very simple to analyze the holdings of a given fund versus its benchmark, it can be very tricky to get results that matter. The first pitfall is the data quality, since it only makes sense to compare different datasets when the data are of high quality. One of these issues is the date on which the datasets are derived, since that may lead to larger differences in the holdings.
Another pitfall with regard to the quality of the data is the fact that derivatives within the fund portfolio need to be classified correctly in order to measure their impact within the active share.
But these are not the only pitfalls from the data input. Often, it is overlooked that a fund by definition of its investment style and /or investment objective may invest in a given market/investment universe, but it does not follow a common benchmark at all. This may lead to a high active share, when it is in fact only misdirection.
One example of this can be found in funds such as value or growth funds that use a unique investment style. With regard to their investment style these funds exclude a number of securities held in the benchmark, since they are not suitable for a given fund from the portfolio manager’s point of view. The difference in holdings would be reflected in the active share as a high value, which would point the analyst in the wrong direction. This shows that it is key to use an appropriate benchmark to evaluate the active share of a fund; a number of funds may invest in a given market, i.e., equities global, but they have nothing in common with the particular market benchmark (in this case the MSCI World), since the investment style of the fund defines an investment universe that differs by definition from the general market. Even the use of more specialized market benchmarks does not help in general, since the investment objective and style of the fund might not be represented correctly in a benchmark.
With regard to the above, the active share measure seems to not be the best measure to identify real active funds within a given peer group, since there are numerous reasons a fund can show a high active share compared to a given benchmark. But active share can definitely be used to identify funds that obviously do index hugging, therefore helping to identify funds that charge investors for active management when the fund manager follows a rather passive strategy.
Even though it seems to be likely that a fund with a high active share is going to outperform its benchmark in absolute terms, that does not tell anything about the realized risk-adjusted returns of the fund compared to its benchmark. I would say active share is an additional measure that can help a fund selector identify funds that are not as active as they should be, rather than a measure that helps to select funds with high outperformance potential. I see active share as being only an additional tool to help the investor make more educated decisions in the fund selection process.
The views expressed are the views of the author, not necessarily those of Thomson Reuters.