Putting Large-Cap Active Share to the Test

Last week's column, in which we reviewed active share among the 20 largest large-cap funds, sparked a lively discussion among some Morningstar.com readers not only about the findings but about the value of the active share metric itself. Active share, you'll recall, measures the degree to which a fund's portfolio resembles that of its benchmark. A fund with no holdings in common with the benchmark would have an active share of 100, while one that's a perfect match would have an active share of 0. Not only which holdings but their weightings within the portfolio are factored into the active share metric.

Funds with portfolios that closely resemble their benchmarks are sometimes derisively called "index-huggers" or "closet indexers." Given that actively managed funds generally charge much higher fees than index funds do, it makes little sense to own an actively managed fund that looks somewhat like the index when you can own the index itself for a fraction of the cost, or so the thinking goes.

A few readers questioned whether active share and performance are related. After all, a fund may hold a collection of stocks that is almost entirely different from the benchmark, but that hardly means they'll outperform. Indeed, stepping too far away from the benchmark for the single-minded purpose of differentiating a fund's portfolio could have disastrous results. And even though some studies have suggested that high active share leads to outperformance, a recent study by Fidelity, which Morningstar's John Rekenthaler wrote about in his own column, found that in fact some large-cap funds achieve both high active share scores and excess returns by holding small-cap stocks, which typically aren't included in the large-cap benchmark and which may outperform large-cap stocks during long time periods.

Another question readers raised was whether fund size plays any role in active share. Could larger large-cap funds (in terms of assets) be at a disadvantage relative to their smaller-asset-base counterparts in this regard? An enormous fund such as  Fidelity Contrafund (FCNTX) ($106 billion in assets) will have a much more challenging time moving the dial in terms of its performance by investing in smaller companies than a large-cap fund with a much smaller asset base would.  

In an effort to answer these questions we went back to the Morningstar Direct platform and pulled more active share numbers, this time with performance and fund size in mind. (Morningstar Direct is our product designed specifically for institutional investors.) From the list of all actively managed large-cap funds, we pulled three groups based on the size of their asset bases. The first was made up of the 50 largest funds (ranging in asset base from $10 billion to $136 billion), the next included 50 with around $1 billion in assets (from $1 billion to $1.3 billion), and the last included 50 with around $100 million in assets (from $100 million to $150 million). For our active share benchmark we once again used the S&P 500. Here are the results.

Large-Cap Fund Active Share by Fund Size
	Avg. Active Share	Avg. 10-Year Return*	Avg. Star Rating
Largest Large-Cap Funds	70.1	8.76	3.7
$1.0B-$1.3B in Assets	77.9	7.77	2.7
$100M-$150M in Assets	75.9	6.62	2.5
S&P 500	--	7.77	--
* Annualized Actively managed funds only Data as of May 30

The Average Active Share column seems to support the notion that larger funds tend to resemble the benchmark more than their smaller counterparts, though not consistently across asset base sizes and not by a tremendous amount in any event. Would you shy away from a fund with an active share of around 70 but be content with one with an active share closer to 80? If so, then some of these larger funds may not be your cup of tea. But before you decide, make sure you look at the other columns on our table. Clearly the larger funds have been the stronger long-term performers on average despite their lower average active share. Also bear in mind that active share represents a snapshot of a fund's portfolio on a given day (the date that it reports its holdings), and this will change over time. So the funds included in these calculations may well have had active share numbers that were higher or lower in the past, just as they may be higher or lower in the future.

This is not to suggest that large-cap funds with bigger asset bases are inherently better than smaller large-cap funds. Obviously some larger large-cap funds have been below-average performers while some smaller large-cap funds have been above-average. But it is clear that just because a fund has a lower active share than another does not make it inferior. It may make you, as the shareholder, feel better knowing that a fund manager is following his own path rather than merely copying the index. But whether an actively managed fund ultimately is worth its expense ratio comes down to the manager's skill and performance, not merely what his portfolio looks like.

One last note about our S&P 500 benchmark: Some readers questioned whether the index, which has a large-blend orientation, is the right benchmark to use when measuring active share for large-growth and large-value funds. It's a valid point given that active share can be calculated using any benchmark, including those more geared toward funds with growth or value tilts. Here we've chosen to use the S&P 500 as our benchmark across the board partly for the sake of simplicity but also because funds that track it are widely available and an obvious alternative for investors seeking passive exposure to large-cap companies. However, in order to isolate the investment-style variable, we looked at active share relative to the S&P 500 among the 50 largest large-cap funds broken down by category.

Active Share Among 50 Largest Large-Cap Funds by Category
Category	Avg. Active Share
Large Value	67.0
Large Blend	69.2
Large Growth	72.7

Interestingly, the 16 large-value funds among the top 50 actually have the lowest active share, meaning they look more like the index than even the average large-blend fund here. Next come the 12 large-blend funds, followed closely by the 22 large-growth funds. All in all, the differences among these three fund groups is rather slight, so the larger points highlighted above still hold.