What is ‘active share’ and how can it help investors choose funds?

‘Active share’ has become an important measure of assessing actively-managed funds that aim to beat the market. These funds stand in contrast to ‘passive’ investments or ‘trackers’, which simply aim to replicate the performance of a benchmark index by holding its components.

By comparing how many holdings an active fund has in common to its benchmark, for example the FTSE All Share for UK shares, it is possible to establish how ‘different’ it is and therefore the extent to which it may deviate from it in terms of performance.

The concept was initially developed by Cremers and Petajisto (Yale) in 2006, who sought to define where a fund lay on a spectrum between passive and active. If you want to understand how active share is calculated, here’s a simple rule to remember: If all a fund’s holdings were the same as the benchmark, its active share would be 0%. Whereas, if a fund has no holdings at all in common with its benchmark, it would have an active share ratio of 100%.

What is considered a high active share?

A high active share is generally considered to be around 80% or above. Cremers and Petajisto believed that a fund with an active share below 60% should be classed as a ‘closet-tracker’ – an active fund that in reality is unlikely to diverge much from its index in terms of performance. Indeed, it would likely underperform after charges.

Cremers and Petajisto found that high active share funds were more likely to significantly outperform their benchmarks. This is intuitive as the more different a fund is to the broader market the more scope it has to perform differently. However, different doesn’t automatically equal better, and outperformance relies on the skill of the fund manager. What you can expect from a fund with high active share is that performance could deviate significantly from its benchmark – for better or for worse. Subsequent studies have confirmed that ‘dispersion’ of returns from funds increases with higher active share.

Have there been criticisms of active share?

There has been plenty of other research and analysis on the subject of active share, some which supports the initial findings and others which question it. In reality, active share is just one useful metric of a broader checklist. It is unwise to place too much emphasis on it, especially if using it as a snapshot at one point in time.

Understanding how a fund is different to its index and not just to what degree is also vital. For instance, the Cremers and Petajisto study may have been heavily influenced by the excess returns generated by the smaller companies owned by many of the active fund managers. In aggregate, smaller firms beat larger index constituents over the period, so any manager with a bias to these would have had a good chance of outperforming regardless of their level of skill.

In this example, a manager generating outperformance from investing only in larger firms would have been more impressive; just one example of how active share combined with past performance figures don’t tell the whole story. Similarly, other structural ‘biases’ of funds due to a manager’s approach or style can also result in better or worse returns over a given period, including industry, sector or geographical positioning, and whether a manager is ‘growth’ or ‘value’ orientated.

It is also important to note that active share isn’t useful in comparing funds of different types. For instance, indices with much greater concentration (a higher percentage in the top 20 holdings, say) are harder to consistently exhibit a higher active share against, for example single emerging markets countries. Similarly the index’s weighting methodology is a important to the calculation. It must be remembered that large company funds will tend to have a lower active share and small caps funds naturally have a higher active share given the increased choice for managers.

Different is good – but no guarantee of success

Different doesn’t automatically equal better, but we do believe in order to beat a benchmark over the longer-term, it’s important to be different to it. If we are paying typically higher fees for active management then that is what we should be demanding. So-called ‘closet-tracking’ where fees are high and active share consistently low is a sure-fire way to underperform.

The actively-managed funds on our Preferred List that invest in equities are typically in the 80-90% region. Although there are some outliers – for instance, Scottish Mortgage Investment Trust is typically in the mid-90s given its highly differentiated approach. Meanwhile, some of the more specialist and country-specific funds are lower, in the 70-80% region, given the effects described above.

Being different comes at a price, though. Not only can underperformance result from investment ‘style’ or other factors being at odds with market trends, but the higher the active share the greater the dependence on manager skill.

How can you check active share?

Some funds publish their active share figure on the fund factsheet. If not, comparing the top ten holdings (or more if available) with that of the index offers a decent proxy – especially if cross checking with a performance chart. If the fund’s performance deviates little from the market and the top ten looks similar then the fund could be a ‘closet tracker’ candidate.

Investment ideas

Explore our Preferred List for a curated list of funds and trusts that are overseen by experts.