Active share: What is it good for?
When choosing the best funds to invest in, a high active share has become a requirement for many investors. But is it really wise to make investment decisions based so heavily on active share, particularly given the recent challenging performance of some high profile, high active share funds?
What does active share tell us?
In simple terms, active share provides a snapshot of how much a portfolio differs from its benchmark. In the academic paper that first introduced the world to active share back in 20091, Martijn Cremers and Antti Petajisto define active share as the percentage of the total portfolio that is invested differently from the benchmark (the sum of the absolute value of the active stock weights, divided by two).
A long only portfolio will have an active share between 0% (if it is identical to the benchmark) and 100% (if there is no overlap with the benchmark whatsoever). Funds will tend to have a high active share if they have large weightings in stocks relative to the benchmark weight, if they have small or no positions in stocks that have large weightings in the benchmark, if they hold stocks outside of the benchmark including unquoted names.
Because active share highlights the amount of active risk that a fund is taking relative to a benchmark index, the measure is perhaps most useful for identifying funds that charge an active management fee but which are in reality closet index trackers. Active share also responds instantly to changes in fund positions, making it a useful tool for identifying occasions when a fund manager is drifting away from his or her mandate before it shows up in fund performance.
What are the limitations of active share?
While active share is an intuitive and readily available yardstick by which to gauge the level of active exposure across funds, investors need to be aware that active share actually tells us very little about how much risk is being taken in a fund.
For example, a fund can achieve a high active share by taking one big bet in one stock, or from lots of small active positions. Similarly, funds with a small cap bias, or with large off-benchmark positions, will inherently have a high active share, while large cap funds will naturally have lower active shares versus their small cap peers because large cap benchmarks are more concentrated.
Furthermore, factor-based funds that target portfolio exposure to overall return factors (for example, momentum, value, quality), with less of an emphasis on stock-specific risk, will likely have a lower active share. As such, active share tells us nothing about the style or factor exposure of a fund.
In reality, all the evidence suggests that risk actually increases as active share increases—but perhaps more importantly, the relationship between risk and active share is not linear. The level of “blow-up” risk is significantly higher for high active share funds. Fidelity’s analysis on active share and manager selection warns that “higher levels of active share come with greater levels of return dispersion, and higher downside risks, as well.” The same analysis also shows that there is often a “positive correlation between active share and a portfolio’s ‘worst case scenario.’”3
Can active share predict funds that are more likely to outperform?
Since the original thesis on active share was published, studies have shown active share to be a good predictor of outperformance. At the same time, some investors and advisers have increasingly used active share as a selection tool to indicate the potential for a manager to produce alpha in the future. However, while funds with a high active share have tended to outperform over time, crucially they have produced most of their returns during certain periods.
For example, a large portion of the excess returns produced by high active share funds over the last 20 years was produced around the turn of the millennium. The strong outperformance of high active share funds at the time of the dotcom bubble is perhaps unsurprising, however, given markets were driven by the rapid growth of technology stocks that were either unquoted or very small parts of market indices. Funds with exposure to these fast growing stocks would inherently have had a higher active share.
The outperformance of funds with a high active share also reflects the fact that high active share funds are more likely to be small cap funds (as shown earlier). So the performance data is really only confirming the fact that small cap stocks tend to outperform their larger peers over the long term—a phenomenon first noted by Eugene Fama and Kenneth French in their three factor model to describe stock returns published some 27 years ago.4
Interestingly, while the outperformance of high active share funds can be explained by market cap biases and underlying drivers of market returns, there is little evidence to suggest that active share has any predictive power when comparing funds with the same benchmark—as shown in AQR Capital Management’s 2015 paper “Deactivating Active Share”.5
Finally, it’s also worth thinking about the survivorship bias that is incorporated in active share performance data. Because high active share funds are more risky, they are also more likely to suffer severe underperformance and be closed down, removing them from the data set and flattering the performance of the remaining high active share funds.
Conclusion: Use carefully
Active share is a useful tool for investors, particularly when looking to identify closet index tracking funds. But investors should tread carefully when using hard and fast rules about active share levels to select funds, or when linking high active shares to future alpha generation.
Other factors—such as fund benchmarks, tracking errors, information ratios and levels of portfolio concentration—all need to be considered, along with active share, to get a rounded view of the risks of investing in different funds.
Unfortunately, the most important aspect of fund selection cannot be easily quantified: manager skill. Finding managers with high skill levels should remain the key focus for investors looking to unlock long-term outperformance.
Zach Chadwick is an analyst within the J.P. Morgan Asset Management UK equity team. Read more about our UK Capabilities >
 Cremers, M., and A. Petajisto, 2009, How active is your fund manager? A new measure that predicts performance, Review of Financial Studies, 22
 Active Share: Looks like a lion, manages like a lamb, https://www.hermes-investment.com/ukw/wp-content/uploads/sites/80/2015/09/looks-like-a-lion.pdf
 “Active Share: A Misunderstood Measure in Manager Selection” https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/leadership-series_active-share.pdf
 Eugene Fama and Kenneth French, 1992, “Common risk factors in the returns on stocks and bonds”.
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