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Last month, I wrote about the predictive power of
fund expense ratios. Using the success ratio (the
percentage of funds that survived and outperformed),
I showed that your chances of a successful outcome
grow dramatically as you move to cheaper funds.
Cheap funds are more than thrice as likely to survive
and outperform as high-cost funds.
But what about active share? It’s a highly touted
measure that determines how different a fund’s port-
folio is from its benchmark. It is the inverse of overlap,
so a high active share means a fund is very different and
a low one indicates a fund is similar to its benchmark.
For example, a fund with an active share rating of
100
relative to the S
&
P
500
would have no holdings in
common with the index, while a fund with an active
share rating of
0
would have identical holdings (such
as an S
&
P
500
index fund). Early advocates said this
measure was a good predictor of future performance.
More recently, some have said that it’s
OK
to have
high expenses if you have high active share. My
response: Balderdash!
I put active share through the same tests as expense
ratios. As with fees, I broke U.S. equity funds into
quintiles based on their active share relative to their
peer group as of Jan.
1
,
2011
. Then, we looked
to see how they did over the subsequent five years
ended December
2015
.
What Did I Find?
The quintile with the highest active share among U.S.
equity funds had a meager
29%
success ratio followed
by
27%
for the second quintile,
32%
for the middle
quintile,
40%
for the fourth quintile, and
43%
for the
least-active quintile. Returns of the surviving funds
likewise showed that active share hurt performance.
The most active quintile had returns of
9
.
3%
com-
pared with
9
.
7%
for the middle quintile and
10
.
6%
for
the least active quintile. This is a little worse than
previous times I ran the test. In those tests, active
share was closer to a neutral impact on results than
the negative impact we see here.
For the sake of comparison, the cheapest quintile
of U.S. equity funds had a success ratio of
64%
compared with
16%
for the priciest quintile. The high
active-share quintile’s
29%
success ratio was com-
parable to the
28%
success ratio registered by the
fourth (or second-priciest) quintile of fees.
Active share’s ability to predict investor returns and
risk-adjusted returns as measured by Morningstar
Ratings was also weak. The highest active-share quin-
tile had a
24%
success ratio for investor returns
compared with
28%
for the least active share. Using
five-year star ratings, the highest active-share
quintile led to an average star rating of
2
.
6
while the
least active had
3
.
2
. It’s not surprising that risk-
adjusting returns through the lens of the star rating
would not help active share’s case, as more-focused
funds are more volatile in general.
So, what’s wrong with active share? I see a few
problems. First, it’s often mistaken for a measure of
skill, but that’s not what it is. I could take a portfolio
and add some short positions or out-of-benchmark
long positions to boost active share, but would that
necessarily improve returns? Only if I had skillfully
chosen those shorts and nonbenchmark long posi-
tions. Second, it just doesn’t add up. You could carve
the S
&
P
500
into
50
separate portfolios with high
active share but you would not improve returns by
1
basis point.
I do find active share useful in a similar way that
R-squared and tracking error tell you if a fund is
behaving like an index. Only in this case it measures
holdings overlap with an index rather than corre-
lation of returns. Our analysts monitor changes to a
fund’s active share for signs that a manager is
changing his strategy. For example, if a fund gets a
lot of assets in a short period of time, active share
may go down, and that tells me asset bloat is having
an impact on a fund’s strategy. So, it’s a fine
descriptor, just not a predictor.
K
Active Share: The Road to Nowhere
The Contrarian
|
Russel Kinnel
Our Contrarian Approach
I go against the grain to
find overlooked funds that may
be ready to rally.