A simple truth lies at the root of fund management: Actively managed funds need to differentiate themselves from their benchmark in order to be able to outperform it after fees. By measuring this difference, the concept of active share can be a useful tool for investors to gauge the degree of active management at the portfolio level. However, investors using active share in the process of their fund selection should be aware of its characteristics and limitations.
What to Consider When Using Active Share
Active share provides insight into just one dimension of active management. Activeness on the stock level is one side of the coin, as factor bets can also be used to deviate from the benchmark. Metrics such as R-squared, tracking error, style bias, or portfolio concentration can also serve as yardsticks for active management. Hence, we recommend using active share in combination with other metrics in the fund analysis toolkit to make a robust assessment of the level of active management applied.
Active share only measures the proportion of a fund’s assets invested differently from the benchmark. It is notably silent on the prudence of those divergences from the index.
Active share is only indicative for long-only funds that don’t invest in derivatives, other funds or ETFs.
The level of active share is highly dependent on the benchmark selected. Benchmarks can vary in their number of constituents, weighting mechanism, and concentration of holdings. A high active share can therefore imply active management, but may also simply indicate the selection of an inappropriate benchmark.
If a proper benchmark is used, high active share can still signal portfolio style bias or drift, which might expose investors to unintended or undesirable risk factors. For instance, we find that an increase of active share was accompanied by an increase in exposure to lower market capitalisations. Given this, it can be useful to augment active share with returns-based style analysis that more precisely measures a strategy’s sensitivity to factors that a holdings-based approach might not capture.
Benchmark construction influences the level of active share. Depending on risk constraints, a portfolio manager who is benchmarked against a very concentrated index such as the MSCI Europe/Energy Index may well have to include top-constituents such as Total. The UCITS 10/40 rule, which limits managers to a maximum position size of 10%, and only a maximum of 40% of a fund's assets may be in positions of between 5% and 10%, can also limit a portfolio manager's ability to express her positive view on a stock, or conversely, force her to underweight the benchmark in top holdings.
Active share measures the activeness of a portfolio at a single point in time. Although active share levels are fairly stable over time for most funds, a change in manager or strategy can result in large shifts in the level of active share. Market and inner corporate circumstances also appear to influence portfolio managers' willingness to take active bets.
As active share increases, so does dispersion in annualized excess returns, standard deviation, maximum drawdown and tracking error. Portfolios with the same level of active share can exhibit various levels of excess return and risk. This implies that active share alone is not sufficient to generate alpha and consequently investors have to do more research to select superior funds.
How to Be a Smart User of Active Share
With the above mentioned characteristics and limitations taken into account, how could one be a smart user of active share in fund analysis? We list some recommendations below:
Higher active share is not necessarily better. Chasing high active share funds can result in selecting the strongest outperformer, but also the worst underperformer. It is the portfolio managers’ skill of selecting the right deviations from the index that generates outperformance.
Keep track of style differences versus the benchmark and make sure no unintended bets in terms of style or size are taken by the manager.
Avoid funds that combine a low active share and a low tracking error (closet indexer) with above-average fees, as these products have only a small chance of outperforming after fees in the long run. Investors seeking a performance close to the benchmark should opt for a low-cost passive fund or a very moderate priced actively managed fund instead.
Fees are an important factor and Morningstar has previously demonstrated the negative relationship between fees and mutual fund performance. Investors should be skeptical of expensive funds. Generally speaking, fees tend to go up as active share rises. However, this doesn’t imply that all funds with higher active share are expensive. Instead of looking at the absolute level of fees, we think investors should look at the fee paid per unit of active share as a yardstick for fair payment.
Conclusion
To conclude, we believe active share can be a useful tool for investors to analyse the activeness of a fund. Nevertheless, the beauty of its simplicity can also turn out to be its biggest weakness.
In selecting funds, combining active share with measures of risk, such as tracking error, can be fruitful in understanding the style of a fund and being able to analyze its performance and qualities against other funds with similar styles. Morningstar’s research shows that risks grow as active share rises, which leads to a trade-off. It emphasizes the need to be very careful when selecting funds with high active shares. To understand the capabilities at the asset management company, how stocks are selected, how risk is managed, and so on, a qualitative approach is helpful to back up the quantitative analysis. There are many ways one might approach the matter. Morningstar's manager research team’s qualitative methodology, as embodied in the Morningstar Analyst Rating, provides one such example.
This article is based on the conclusions of Morningstar’s recent research report: “Active Share in European Large-Cap Funds”. It has been written by the study’s authors Mathieu Caquineau, CFA, Matias Möttölä, CFA, and Jeffrey Schumacher, CFA.
