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Active ingredient

What Is Active Share?

Active Share is a key metric in Investment Analysis that quantifies how much a portfolio's holdings differ from its benchmark index. Expressed as a percentage, it measures the proportion of a fund's portfolio that is not replicated in its chosen benchmark. A higher Active Share indicates a greater deviation from the benchmark, suggesting a more active Investment Strategy, while a lower Active Share implies the portfolio closely resembles the benchmark. This metric helps investors assess the true level of Active Management being employed by a Fund Manager.

History and Origin

The concept of Active Share was introduced by Martijn Cremers and Antti Petajisto in their influential 2009 paper, "How Active Is Your Fund Manager? A New Measure That Predicts Performance," published in the Review of Financial Studies. Their research aimed to provide a more robust measure of active management beyond traditional metrics like turnover or tracking error. Cremers and Petajisto posited that funds with high Active Share were more likely to generate Alpha, or excess returns, over their benchmarks compared to funds with low Active Share. The seminal paper is a cornerstone in understanding active portfolio construction.9,8

Key Takeaways

  • Active Share measures the percentage of a portfolio's Portfolio Holdings that differ from its Benchmark.
  • A higher Active Share (closer to 100%) suggests a truly active approach, while a low Active Share (closer to 0%) may indicate "closet indexing."
  • It is not a measure of skill, but rather the degree of active bets taken against an index.
  • The metric is widely used in assessing the activeness of equity Mutual Funds and exchange-traded funds (ETFs).
  • While initially correlated with Outperformance in early studies, subsequent research has presented a more nuanced view.

Formula and Calculation

Active Share is calculated by summing the absolute differences between the portfolio's weight and the benchmark's weight for each security, then dividing by two. This division by two ensures the measure ranges from 0% to 100%.

The formula is expressed as:

Active Share=12∑i=1N∣wfund,i−wbenchmark,i∣×100%\text{Active Share} = \frac{1}{2} \sum_{i=1}^{N} |w_{\text{fund},i} - w_{\text{benchmark},i}| \times 100\%

Where:

  • (N) = the total number of securities in either the fund or the benchmark
  • (w_{\text{fund},i}) = the weight of security (i) in the fund's portfolio
  • (w_{\text{benchmark},i}) = the weight of security (i) in the benchmark index

For example, if a security has a 2% weight in the benchmark and a 3% weight in the fund, the absolute difference is 1%. This difference contributes to the Active Share. If the fund does not hold a security present in the benchmark, or vice versa, the entire weight of that security contributes to the Active Share.

Interpreting the Active Share

Interpreting Active Share involves understanding what different percentages imply about a fund's approach. A fund with an Active Share near 100% holds a portfolio completely distinct from its benchmark, indicating a high-conviction, stock-picking strategy. Conversely, a fund with an Active Share approaching 0% is essentially an Index Funds and is likely engaged in Closet Indexing, where it mimics the benchmark but charges fees typically associated with active management.

An Active Share between 60% and 80% often suggests a moderately active fund, taking significant but not extreme positions away from the benchmark. For investors seeking true active management, a higher Active Share is generally preferred as it signifies the fund manager is truly attempting to add value through security selection rather than simply hugging the index. It's important to consider Active Share alongside a fund's Expense Ratio to evaluate the value proposition.

Hypothetical Example

Consider a hypothetical mutual fund, "DiversiGrowth Fund," and its benchmark, the "Broad Market Index."

  1. Broad Market Index: Consists of 10 stocks.

    • Stock A: 20%
    • Stock B: 15%
    • Stock C: 10%
    • ... (7 other stocks)

  2. DiversiGrowth Fund's Portfolio:

    • Stock A: 10% (underweight compared to benchmark)
    • Stock B: 25% (overweight compared to benchmark)
    • Stock C: 0% (not held, significant difference)
    • Stock X: 5% (held by fund, not in benchmark)
    • ... (other stocks)

To calculate the Active Share, we would take the absolute difference for each stock. For Stock A, (|0.10 - 0.20| = 0.10). For Stock C, (|0.00 - 0.10| = 0.10). For Stock X, (|0.05 - 0.00| = 0.05). Summing these absolute differences for all stocks in either portfolio, and then dividing by 2, would yield the Active Share. If, for instance, the total sum of absolute differences is 1.20, then the Active Share would be (1.20 / 2 = 0.60), or 60%. This 60% indicates that 60% of the fund's holdings differ from its benchmark, reflecting a moderately active approach.

Practical Applications

Active Share is primarily used by investors and analysts to:

  • Identify truly active funds: It helps differentiate genuinely active managers from "closet indexers" who charge active fees but offer index-like returns. Regulatory bodies, for instance, may scrutinize funds with consistently low Active Share.
  • Evaluate manager conviction: A high Active Share suggests a manager has strong convictions about their unique stock selections, indicating a willingness to deviate significantly from the market consensus.
  • Complement other metrics: While not a standalone predictor of future performance, Active Share provides valuable context when combined with other performance measures, such as Risk-Adjusted Return and expenses.
  • Inform portfolio construction: Investors seeking pure Diversification through passive vehicles might steer clear of funds with high Active Share if they desire strict benchmark replication. Conversely, those seeking potential alpha from active management would favor higher Active Share funds. The growing popularity of low-cost passive funds has led active asset managers to face increasing challenges and outflows.7

Limitations and Criticisms

Despite its utility, Active Share has faced limitations and criticisms:

  • No direct correlation with performance: While initial studies suggested a link between high Active Share and Outperformance, later research, including studies by Morningstar and AQR, found no consistent or systematic link across all categories.6,5 Some studies suggest that the relationship between Active Share and returns is highly dependent on the chosen benchmark and can even be negative for certain factor-based strategies.4,3
  • Benchmark selection bias: Critics argue that the predictive power observed in early studies might have been influenced by the choice of benchmarks. Funds with high Active Share often had small-cap benchmarks, which historically showed different performance characteristics than large-cap benchmarks.2
  • Does not measure skill: Active Share quantifies how different a portfolio is, not why it's different or whether those differences are driven by skill. A fund could have a high Active Share and still experience significant Underperformance if its active bets are incorrect.
  • Focus on holdings, not factors: Active Share solely focuses on individual security holdings and does not explicitly account for exposure to broad market factors, which can be a significant driver of returns in Factor Investing strategies.1

Active Share vs. Tracking Error

While both Active Share and Tracking Error are metrics used to evaluate active management, they measure different aspects.

Active Share quantifies the degree to which a fund's individual security holdings differ from its benchmark. It is a static, holdings-based measure that tells you what percentage of the portfolio is different. A fund with an Active Share of 80% means 80% of its portfolio is not overlapping with the benchmark.

Tracking Error, on the other hand, is a volatility-based measure that quantifies the historical volatility of a fund's returns relative to its benchmark. It indicates how much a fund's returns have deviated from its benchmark's returns over time. A high tracking error suggests significant return divergence, which could be positive or negative. While a high Active Share often correlates with a high tracking error, they are not interchangeable. A fund might have a high Active Share but a relatively low tracking error if its active bets are well-diversified and largely cancel each other out in terms of return volatility, or vice-versa if highly concentrated bets lead to large deviations in performance.

FAQs

What is considered a good Active Share?

There isn't a universally "good" Active Share percentage, as it depends on the investor's objectives. For investors seeking true Active Management and potential for alpha, a higher Active Share (often above 60-80%) is generally considered desirable, as it indicates the manager is genuinely trying to differentiate their portfolio from the benchmark.

Can a passive fund have Active Share?

Technically, a perfectly passive Index Funds designed to perfectly replicate its benchmark would have an Active Share of 0%. However, due to rebalancing needs, cash flows, and minor discrepancies, even passive funds might show a very small, non-zero Active Share. Funds accused of Closet Indexing have a low Active Share but charge fees similar to truly active funds.

Does a high Active Share guarantee better performance?

No, a high Active Share does not guarantee Outperformance. While some initial studies suggested a correlation, subsequent research has shown that the relationship is not consistent or universal. Active Share measures deviation, not skill. A fund manager can make significant active bets (resulting in high Active Share) but still experience Underperformance if those bets are incorrect or if market conditions do not favor their specific strategy.