Active Share: What You Need to Know

Trickier Than It Seems
Of all portfolio measures invented over the past decade, active share has become by far the most popular. Developed by academics rather than consultants (or, ahem, Morningstar), the measure addresses the key investment question of how far the fund deviates from its benchmark.

The calculation is intuitive. Active share compares a fund's portfolio holdings against those of its most appropriate benchmark. When the two diverge, the difference is credited to active share. For example, if Stock A makes up 3% of a fund and is not held by the benchmark, then Stock A contributes 3 percentage points to the fund's active share score. Stock B also makes up 3% of the fund and is 1% of the benchmark. Stock B thus contributes 2 percentage points to the fund's active share--the 3 percentage points that the fund owns, minus the 1 point of overlap with the index.

A perfectly executed index fund receives an active share score of 0. In contrast, a fund that has no overlap whatsoever with an index (suspend disbelief for a moment) would have an active share score of 100.

Adding to the appeal of the active share measure was the paper's finding that fund managers with high active share scores outperformed those with low scores. Perfect! The calculation not only showed which fund managers were truly differentiating their funds and thus earning their keep, but it also helped to identify future winners. You can't ask for more from a statistic than that. 

However, the apparent simplicity of active share belies the complexity of its interpretation. In Active Share: A Misunderstood Measure in Manager Selection, published earlier this year, Fidelity's research group draws out the difficulties.

As Fidelity's paper points out, the level of a fund's active share score depends heavily on the structure of its benchmark.  If the benchmark contains few companies, with the largest firms accounting for much of the assets, then the fund will likely have a lower active share score. The NASDAQ 100 index, for example, has one third of its assets in its four largest positions:  Apple (AAPL),  Microsoft (MSFT),  Google (GOOG), and  Amazon.com (AMZN). A fund that uses that index as a benchmark and that holds only half-weighted positions in those four stocks is being quite active. Yet its active share score will almost certainly be below 80. 

In contrast, it's easy to receive a high active share score when the benchmark is diffuse. The 10 largest holdings in the Russell 2000 index account for only 3% of its total assets, with the index's top position registering at less than 0.5%. A timid manager could purchase 200 of the Russell 2000's holdings while matching the index's sector weightings, thereby building a widely diversified portfolio that would closely track the index--and receive an active share score of 90. Looks like a lion, manages like a lamb.

Here are the active share scores of all U.S. diversified stock funds, courtesy of Fidelity. 

  - source: Fidelity Investments

Now the same picture, distinguishing between large- and small-company funds. 

  - source: Fidelity Investments

Now that is a pattern. 

Curiously, Fidelity doesn't follow this observation to its logical conclusion. If funds with high active share scores are mostly small-company funds, and funds with high active share scores are better at outperforming their benchmarks, does that mean that small-company funds are superior at beating their benchmarks?

Why yes, it does. 

However, Fidelity does ask another relevant question. If the most successful large-company stock funds are those that have high active share scores, and small-company stocks tend to outgain large-company stocks, does that mean that "high active share score" may be a proxy for "diversifies into small-company stocks"?

Why yes, it may. That is exactly what is happening, find Fidelity's researchers.

  - source: Fidelity Investments

You get the point.  It is difficult indeed to distinguish between the small-company effect and the active share effect. The two are closely entangled. As that final chart demonstrates, the issue can't even be resolved by separating funds into size groups. The small-company effect leaks into studies of funds that have large-company benchmarks, too.

Active share is a fine descriptive tool. It accurately describes how much a fund's holdings differ from those of its benchmark. (Even there, one must be careful with the interpretation, as seen by the timid-manager example. It's quite possible to run a index-focused portfolio while still receiving a high active share score.) It is not clear that it is a useful prescriptive tool.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.