Following several challenging years, some market participants are expecting that 2017 may be a better year for active management, given the potential for a continued rise in interest rates and more volatility in equity and bond markets. Active managers generally have more opportunity to outperform when volatility is high (potentially creating opportunities to buy low and sell high), and when asset classes and individual securities see more dispersion in returns (versus the “rising tide lifts all boats” market experienced in recent years).
The financial industry often lumps all active funds into one bucket, but in reality there are a continuum of products, as shown in the figure below. On the left are managers who have portfolios that are not very differentiated from the benchmark they follow. These types of managers, which we refer to as closet indexers, may have a hard time generating enough return in excess of their benchmarks (alpha) to cover their fees. On the right are managers whose portfolios are more differentiated from their benchmarks, which may offer a higher potential to outperform even after the impact of management fees.
So how do investors tell the difference? A metric called active share can help. The concept of active share was developed in 2009, as a systematic way of determining how much a fund deviates from its benchmark. A study conducted by Cremers and Petajisto found that historically, “funds with the highest active share significantly outperformed their benchmarks, both before and after expenses, and they exhibited strong performance persistence.”
Like any piece of data, active share just tells one piece of the story and shouldn’t be relied upon as the only factor when purchasing an active fund. This measure can be misleading if a manager typically holds stocks from outside of the benchmark (i.e., international stocks in a domestic portfolio) or in more diversified asset classes such as small cap stocks, given a larger number of small positions in the benchmark. However, your financial advisor can help you incorporate active share as part of a broader due diligence process to help avoid paying fees for closet indexers, and ensure that the active manager you are using is truly active.