We’ve been hearing a great deal lately about active share.
In fact, it was introduced back in 2006 by Martijn Cremers and Antti Petajisto of the Yale School of Management.
So what exactly is it? Here’s Nick Motson from Cass Business School.
"Effectively what they're saying is, I have a benchmark, and I'm going to measure how different my holdings are from that benchmark. So what I'm going to do for each stock that is in the benchmark, I'm going to take the difference between my holding and the benchmark holding. And I'm going to take the absolute value of that, so if I'm above or below I'm going to take it as a positive number. I'm going to add them all together and divide by two. And by construction I can be anywhere between 0 - so if I have exactly the same holdings as the benchmark my active share is 0 - or if I hold nothing that's in the benchmark and all sorts of other stuff, it will be 100%. And I'll be somewhere between. It's a measure of how much I've deviated from the benchmark."
As regular viewers of Sensible Investing know only too well, the active fund management industry is under huge pressure to demonstrate its worth.
Dr Motson believes that’s why the 2006 study is attracting so much attention.
“I think that what’s happened is that people have seized upon one particular finding that they had. And the finding that they had was that over the sample period they looked at on US funds, those funds that had highest active share actually produced alpha. So on average the funds didn’t produce alpha, they didn’t outperform.”
Some observers have implied that active share is a panacea for underperformance by active managers. But that’s very misleading. Active management is still a zero sum game, and a negative sum game after costs.
“Managers who are high-conviction managers, who have ability and are confident in their ability, will choose to take high Active Share. Managers who aren’t will choose to track much closer to the index. So if you start telling people, We’re only going to investing in high active share funds, then those managers who maybe aren’t quite so skilled may also start to take high active share and the whole thing disappears.”
And there is another important issue for investors here. Many investors are paying for what they assume are actively managed funds but actually aren’t.
“What they’ve been getting is someone who says, 'Oh yes, I’m an active manager', when in reality they’ve been hugging the benchmark extremely closely. And that’s what the Scandinavians are mandating - that everyone has to disclose their active share, so that you can’t charge people for something that you’re not providing. But if you’re paying for active you should get active, and if you’re paying for passive you expect passive. And the cost difference between the two is huge.”
And we’ll be looking in more detail at so-called closet index tracking in our next video.