For Active Funds, Being Different From the Index Isn’t Enough

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The popular active-share metric was designed to find mutual funds that simply mimic an index-fund-like portfolio while charging steeper active-management fees. But it may not be as adept at finding winners.

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“If you buy an actively managed fund, at the least you want to make sure that the higher fee you pay gives you a different product than what you can get at a very low price,” explains Martijn Cremers, the co-creator of the active-share metric, which measures the percentage of a mutual fund’s portfolio that differs from its benchmark.

The metric, birthed by Cremers and another finance professor at the Yale School of Management in 2009, quickly became a popular statistic that fund managers promoted to justify their fees. Yet a report published in November by Morningstar titled “Unattractive Share” reveals how poor a fund-selection tool it has been on its own.

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Analyzing returns in every US stock Morningstar fund category from Jan. 1, 2003, through Dec. 31, 2020, the report’s author, Robby Greengoldfound that “across all categories, high-active-share funds exhibited higher risk than their low-active-share peers,” and “high-active-share funds failed to deliver superior net-of-fee results in any category.”

Interestingly, before deducting fees, funds with the highest active-share metrics in the Large Value, Large Blend, and Large Growth categories outperformed their low-active-share peers, but because their fees were higher than average, they still lagged. “One of the biggest predictors of a fund’s ability to beat its benchmark is the fee that it charges,” Greengold says.

In fairness, active share was never intended to indicate that a fund was a good investment on its own. “It doesn’t help resolve whether or not a manager has any skill,” just whether you’re actually getting active management in the first place, says Cremers, who now teaches finance at the University of Notre Dame. “Think of it more as a basic screening device.” It’s most useful as a way to eliminate closet index funds charging active-fund prices.

In a 2017 update to his original study, Cremers reconfirmed that low-active-share funds with higher-than-average fees generally underperformed their peers from 1990 through 2015. He also found that high-active-share funds outperformed during that period, regardless of fees, if the metric was combined with a low holding duration or turnover ratio—how much the manager trades the portfolio’s stocks. Having a low turnover indicates that managers are committed to their stock picks and will wait for their investment thesis to play out.

Yet even as a basic screening tool, active share is challenging to interpret for many fund categories. “Active share has little use within the small-cap and mid-cap categories, because the distribution of active share in those categories is relatively tight,” Greengold says.

Consider that the small-cap Russell 2000 index recently had 2,018 stocks, each with a portfolio weighting of less than 0.5%. Even if an active fund holds hundreds of small-cap stocks and performs like the index, it will have a high active share.

Because, at the end of 2020, Greengold’s study found that “all six small- and mid-cap categories…have [median] active shares of 85% and above.” By contrast, Large Growth’s 60% median active share ranked lowest of all domestic categories. That fund category’s benchmark, the Russell 1000 Growth Index,
has only 500 stocks, and its top 10 stocks accounted for 44% of its total capitalization.

These included some of the most popular names on Wall Street, such as Apple (ticker: AAPL), Microsoft (MSFT), (AMZN), and Tesla (TSLA). It would take a truly bold active manager to avoid these companies and risk being wrong. Thus, an 85% active share is far more impressive in large-caps than small.

In fact, Greengold’s research indicates that as the great bull market in growth stocks from 2009 through 2020 progressed, the median active share in Large Growth funds fell 20 percentage points because those tech giants drove performance.

The way most managers achieve a high active share is by concentrating their portfolios in their “best ideas,” so they hold fewer stocks than their benchmarks. Greengold found that such focused funds charge higher fees than more-diversified low-active-share ones, with low-active-share fees averaging 0.60% to 1.10%, depending on the fund category, versus 1.10% to 1.60% for high-active -share ones.

Concentrated portfolios are more volatile and thus less consistent in their performance than diversified ones. Outperformance, when it does come, can be in bursts—which raises the question of whether most investors can stomach lagging behind the benchmark for years before even a good active manager’s investment thesis plays out.

There are low-active-share funds with modest fees that outperform. Two that Greengold identified are JPMorgan US Value (VGRIX) and American Funds American Mutual (AMRMX). JPMorgan US Value has beaten its Large Value peers in nine out of the past 10 calendar years, despite having a 63% active share and a diversified portfolio of about 100 stocks. Its 0.94% expense ratio is below the category’s average, while a newer exchange-traded fund, JPMorgan Active Value (JAVA)—run by the same lead manager, Clare Hart—charges an even lower 0.44%.

“We think that having greater diversification enables the portfolio to not swing as far in either direction,” says Jaime Steinhardt, a JP Morgan investment strategist. “More-concentrated strategies can work really well in one quarter, but then go the other way the next. Then, the clients pull out at the bottom.”

Even when high-active-share strategies work, they may not work for their shareholders.

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