Active share shows whether a portfolio is an index-hugger or a maverick.
Investors paying for active management want to be sure they are getting what they pay for. Over the years, various measures have been created to gauge whether a fund is behaving like an index or charting a different course. The latest entry is a promising one that is based on portfolio holdings rather than performance.
Active share offers a couple of elegant solutions to problems with Modern Portfolio Theory statistics. Created by Yale's Martijn Cremers and Antti Petajisto, active share replaced a one-index-fits-all approach with one that measures funds against all indexes in a database to see which they are most like and uses data from the most similar benchmarks. (You may recall we had Petajisto present the paper at our 2007 Morningstar Investment Conference.)
It's also driven by portfolios rather than performance. While Modern Portfolio Theory stats line up a fund's performance with an index, active share compares portfolios to see how different the fund is based on actual holdings. It's easy to calculate. It's the inverse of a fund's holdings' overlap with its closest fitting index. On one end, a reading of 100 means that the fund has no overlap with the index. In fact, a fund could actually go above 100 if it has short names in the index and has no long positions in it. On the other, a reading of zero means that it is identical to an index.
It's a more precise reading and more up-to-date, as a fund could be positioned differently today than it was when many of the past stats were generated.
Our data suggest that active share is useful as an indicator of how closely returns will track that of the index and how likely it is to outperform. They confirm the work done by Petajisto and Cremers.
However, we found that the raw number (0 to 100) wasn't very useful for small- and mid-cap funds as the greater number of stocks in those universes leads to high active share figures for even funds that have broadly diversified portfolios. For example, the 23-stock large-cap Ariel Focus
Rather than focus on the absolute number, we calculated a percentile rank, which proved to be more useful in understanding which funds were really index-huggers and which were charting a course far from their index. Fidelity Low-Priced Stock's active share percentile ranking in mid-blend is below average for its category, while Ariel Focus is in the top 10% of the large-value category on active share.
We set out to test active share on two fronts. One: Was it a useful gauge of whether a mutual fund closely tracks an index? Or, put another way, would it tell us how active a manager was? Two: Did it help to predict outperformance?