Active Share Study: Definition, Implications, and Insights

The active share study, initiated by researchers from the Yale School of Management in 2006, aimed to dissect the intricacies of mutual fund management. By investigating the divergence between a fund’s holdings and its benchmark index, termed as active share, the study unearthed valuable insights into fund performance and management strategies.

The study, “How Active is Your Fund Manager? A New Measure That Predicts Performance,” was conducted by finance scholars Antti Petajisto and Martijn Cremers. Their research established a noteworthy connection between a mutual fund’s active share value and its performance relative to its benchmark.

Active share, a metric ranging from zero for pure index funds to 100% for funds with no benchmark overlap, quantifies the extent of a fund’s portfolio holdings that deviate from its benchmark index. Traditionally, active management was assessed solely through tracking error, measuring return volatility compared to a benchmark. However, Petajisto and Cremers introduced active share as a complementary metric, offering a comprehensive assessment of a fund’s activeness in both holdings and returns.

A notable revelation of the active share study was the prevalence of “closet index funds,” which constitute approximately one-third of actively managed mutual funds. These funds closely mimic benchmark holdings while charging active management fees. By integrating tracking error and active share, funds were categorized based on their level and type of active management:

– Diversified stock pickers with high active shares and low tracking errors (e.g., T. Rowe Price Small Cap)
– Factor bets with low active shares and high tracking errors (e.g., Investment Co. of America)
– Concentrated stock pickers with high active shares and high tracking errors (e.g., Fidelity Low Price)
– Closet indexers with low active shares and low tracking errors (e.g., Fidelity Magellan)
– Pure index funds with zero active share and tracking error (e.g., Vanguard 500)

The active share study confirmed the conventional wisdom that smaller funds tend to exhibit more active management. Notably, a significant proportion of large funds, particularly those with over $1 billion in assets under management (AUM), were identified as closet indexers.

According to the study’s authors, active management, as measured by active share, is a predictor of fund performance. Funds with higher active shares consistently outperformed their benchmarks both pre- and post-expenses, while those with lower active shares tended to underperform after expenses. This underscores the importance of active management in achieving superior fund performance.

Investors can leverage active share data to gauge the level of active management within mutual funds. Funds with higher active shares may offer greater potential for outperformance, while those with lower active shares may exhibit characteristics of closet index funds.

While active share provides valuable insights into a fund’s level of active management, it may not fully capture all aspects of fund performance. Additionally, active management strategies often entail higher fees, which investors should consider when evaluating fund options.