Research points to flaw in active share when picking funds

The active share of funds can only be truly understood in the context of the market in which they are investing.

When it comes to picking an active investment fund or trust, investors usually want a fund that is deemed different to the broad index. If an active fund’s portfolio looks similar to the that of the index it is potentially a “closet tracker”. Because active funds charge higher fees than index funds and exchange-traded funds (ETFs) for the ability of the manager to choose the best stocks, having a portfolio similar to the index is seen as bad thing.

As a result, one of the key metrics used by investors to evaluate a fund is known as “active share”. This measures how different the portfolio of a fund is compared to the index.

This was first developed by Martijn Cremers and Antti Petäjistö in 2006. The active share of a fund will range from zero (making it an index fund) to 100% (meaning it has no overlap with the benchmark). The researchers looked at US equity funds and determined that a fund must have an active share of 60% to be truly “active”.

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However, according to a new paper form Morningstar, entitled Context Is Everything When Using Active Share, the active share of funds can only be truly understood in the context of the market in which they are investing. The paper found that funds that invest in highly concentrated markets, in which the biggest companies dominate the index, tend to have much lower active shares. Therefore, the 60% minimum does not apply to all active funds.

The paper looked at the median active share for funds across the 43 Morningstar categories. The median active share spanned from 31% to 98%. Morningstar notes: “The wide range of medians already reveals that markets have major qualitative differences, which makes using a single yardstick such as a 60% limit for separating active and closet-indexing funds insensible.”

For example, the Denmark equity Morningstar Category showed that funds have a median active share of 31%, the lowest of all categories. Other single-country markets such as Germany, Switzerland, Singapore, Finland, and Italy also saw relatively low median active shares among funds.

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In contrast, categories encompassing very large markets had much higher median active shares. For example, Europe, global, or China equity all had much higher active share levels. Similarly, small and mid-cap categories have much higher active share funds. The highest median active share was found among global small/mid-cap, Asian ex-Japan small/mid-cap, and Europe small cap.

The paper notes: “Our data set confirms the intuition that top-heavy indexes represent a more difficult investment universe for active managers to build high active share portfolios, at least without taking meaningful off benchmark positions. The median active share is lower in concentrated markets compared with more diversified ones”

In indices looked at as part of the study, those in which the 10 biggest holdings comprised a weighting in the index of 50% or more, corresponded with a median active share of below 60%. The paper notes: “For example, the Swiss large-cap equity markets, as represented by the SPI Index, is dominated by three companies: Nestle SA (SIX:NESN), Roche Holding AG (SIX:ROG), and Novartis AG (SIX:NOVN). They account for 45% of the index, and the index’s top 10% weight stood at 67% at the end of December 2020. The Switzerland equity category’s median active share is only 37% and only around 10% of the funds show an active share above 60%.”