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Business & Real Estate

A new metric can assist mutual fund selection: A new metric can assist mutual fund selection

One of the most widely debated investment approaches among financial planners involves active versus passive management, especially when investing in stocks.

Indeed, this debate has taken on many of the attributes of a holy war.

Those supporting passive investing argue that the odds of any individual investor putting together a portfolio that can consistently beat the average market return – especially in an efficient market – are so low that it’s not worth trying.

Active Share

Active management adherents point to research identifying market and behavioral anomalies of which knowledgeable investors can take advantage.

A relatively recent addition to the fray – a 2006 working paper and two follow-on papers by K.J. Martijn Cremers and Antti Petajisto, then at Yale – introduced a new measure of active management, which they have named Active Share.

The concept of Active Share is both simple and practical. It is defined as the percentage of a portfolio that is invested differently than its benchmark index. Numerically, Active Share will range between 0 percent (the portfolio is identical to the benchmark) and 100 percent (the portfolio is entirely different from the benchmark). Logically the only way you can outperform any index is to be different from it, so it is intuitively obvious that the greater the difference, the greater the likelihood that the fund will either outperform or underperform the index.

If we consider mutual funds to be nothing more than portfolios created by their respective fund managers, then we can identify them as being either passively or actively managed. Passive managers simply replicate some index at a very low cost. Such funds would have an Active Share close to 0 percent. Active fund managers attempt to beat some benchmark or index in two primary ways: through superior security selection or by overweighting or underweighting entire sectors, industries or regions.

Some interesting conclusions reached:

• Portfolios with a high Active Share were more likely to outperform their benchmarks, even on an after-fee basis.

• Active Share is a highly persistent indicator compared to other more volatile statistics. The level of a portfolio’s Active Share this year is a very good predictor of its Active Share next year and thereafter.

In other words, if you can find a mutual fund with high Active Share, it not only has a greater likelihood to outperform its market index, but also to do it consistently over time. That’s pretty powerful.

Those who believe only in passive investing would probably reject Active Share as a useful metric. Not so fast, however.

Supporting arguments

One of the primary supporting arguments for passive investing is the reported fact that the majority of actively managed funds underperform their benchmarks after fees.

Cremers and Petajisto argue that the reason most active funds have underperformed is that they aren’t really active in the first place. They refer to the managers of these low Active Share funds as closet indexers who “unsurprisingly, exhibit zero skill but underperform because of their expenses.”

For active management followers, Active Share probably sounds like the Holy Grail of investing. Unfortunately, one of the biggest challenges in using it is the lack of good data. I have not found any consumer-oriented websites that measure and report Active Share for equity mutual funds. And to do the job thoroughly, each fund’s Active Share may need to be calculated against multiple benchmarks to determine the greatest overlap.

Also, there’s no guarantee that the manager’s approach to investing will continue to work in all economic environments. Nonetheless, Active Share represents an interesting new metric that, when used in conjunction with other measures, may help active investors improve their returns. At the very least, it’s certainly better than simply basing an investment decision on a mutual fund’s past performance.

Los Altos resident Artie Green is a Certified Financial Planner with Cognizant Wealth Advisors. For more information, call 209-4062.

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