WSJ: How Important is "Active Share" for Fund Managers?


Just how active is the manager of your actively managed mutual fund? And how much
does it matter?

A debate is on over the concept of “active share”—a measure of how much a portfolio’s
stocks differ from those in its benchmark. The issue is whether it is a valid way to
evaluate managers.

It all started in a 2006 working paper and 2009 article by Martijn Cremers and Antti
Petajisto, then professors at the Yale School of Management. They suggested ranking
funds from zero to 100% based on how much their holdings diverge from a benchmark
index. An active share of 60%, for example, means that 40% of the fund’s stocks merely
match what is in an index—a mix that would make the fund’s manager a “closet indexer,” the professors wrote.

They concluded that active-share measurement “significantly predicts” fund
performance relative to benchmarks, with a high score translating into better
performance for longer. One proponent of this approach is Virginie Maisonneuve,
chief investment officer, global equities, at Pacific Investment Management Co.’s
London office, who says she looks for portfolios with an active share “north of 70-

Most experts agree that if a manager holds exactly, or close to, what is in an index, he or
she will underperform after the fund’s costs are taken into account, albeit often by
only a small amount.

However, the use of active-share measurement as “an explicit proxy for a manager’s
potential to generate excess return” is a problem, according to Tim Cohen, chief
investment officer of Fidelity Investments.

In a paper this year with Fidelity colleagues, Mr. Cohen points to drawbacks with how
the measure is being used:

• More swings, more misses. The Fidelity paper says that “maximizing active share
neglects the crucial element of considering potential return in the context of risk.” In
other words, great potential rewards might sometimes materialize as big losses.

• Variety, to a fault. A high active share may be a sign of “stock selection practices
that deviate from a stated style of mandate,” the Fidelity paper says. Put another way,
you may think you have U.S. midcap exposure when you buy a mutual fund, but end uphaving more international midcaps than you realized. That may be a problem for those who have carefully crafted their portfolio holdings to have a specific percentage of U.S. midcaps.

The paper offered this example of how risk and deviation from a fund’s mandate can come together in a fund with high active share: Large-cap funds with higher active share seem biased in favor of smaller-cap holdings, which generally are more volatile than large stocks. That indicates that managers are trying to outperform their large-cap benchmark by throwing in small-caps when that sector is doing better.

A Fidelity analysis of data from March 28, 2013, found the weighted average market cap of holdings in the large-cap funds with the top 10% of active share was $26 billion—less than half the average in the S&P 500 ($55 billion) and much lower than the average for all large-cap funds ($40 billion).

Fidelity suggests one way active-share measurement is useful: determining if fees paid to portfolio managers are worthwhile. For instance, it may be worth switching out of an actively managed fund that hugs its benchmark, in favor of a cheaper, passive index fund.

This may be the big takeaway, albeit a familiar one, for small investors. Enjoy your actively managed fund if it is stellar; but if it is so passive as to be more akin to an index fund, it is often better to be in an actual index fund, after costs are taken into account.

See original story here.
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