By LARRY SWEDROE
While there’s no longer any debate that active management underperforms in aggregate, the majority of active funds underperform every year, and the percentage that underperform increases with the time horizon studied. If an investor were able to identify the few future alpha generators, active management could be the winning strategy. The logical strategy, as is the case in almost any endeavour, would seem to be to rely on past performance.
However, an overwhelming body of academic research demonstrates that the past performance of actively managed mutual funds alone does not provide valuable information as to future performance, and (as the annual SPIVA Persistence Scorecards regularly report) there is less persistence of outperformance than randomly expected. So the quest for a metric that could identify the future alpha generators ex ante continued.
Believers in active management were offered hope with the 2009 study by Martijn Cremers and Antti Petajisto, How Active Is Your Fund Manager: A New Measure That Predicts Performance. They concluded: “Active Share predicts fund performance: funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence.” Unfortunately, subsequent research found problems with the conclusions drawn by Cremers and Petajisto:
Andrea Frazzini, Jacques Friedman and Lukasz Pomorski, authors of the 2016 study Deactivating Active Share, found that controlling for benchmarks, active share had no predictive power for fund returns.
Ananth Madhavan, Aleksander Sobczyk and Andrew Ang of BlackRock, authors of the 2016 study Estimating Time-Varying Factor Exposures, found that the measure of active share proposed by Cremers and Petajisto was actually negatively correlated (-0.75) to fund returns after controlling for factor loadings and other fund characteristics. Thus, they concluded that “it is not the case that high conviction managers outperform.”
In its November 2021 paper, Is Active Share Unattractive?, Morningstar found that since 2011 investors in high-active-share funds in all Morningstar categories had paid higher fees, incurred greater risks, and earned lower returns. While it may have provided a ray of hope at one point, as Andrew Berkin and I demonstrated in our book, The Incredible Shrinking Alpha, the markets have become increasingly efficient over time, raising the hurdles for active management.
In a related 2022 study, Fund Concentration: A Magnifier of Manager Skill, Chris Tidmore found that alpha had near-zero correlation with concentration in aggregate.
The quest continues
With the evidence against active share mounting, researchers have continued their quest to find a metric that would identify, ex ante, future alpha generators. For example, Martijn Cremers, Jon Fulkerson and Timothy Riley, authors of the 2022 study Active Share and the Predictability of the Performance of Separate Accounts examined if active share combined with past performance was a predictor of mutual fund performance. Unfortunately, they found no statistically significant evidence that the combination could predict the future performance of mutual funds. And while they did find evidence that, using the double sort, they could identify separate account managers who would go on to outperform, that was true only for small stocks, not large stocks, which make up about 90 percent of the market cap.
Summary
Given the potential rewards, and the incentives the active management community has given their higher fees, it is no surprise that the quest for the metric that can provide the holy grail of outperformance continues. With that said, in the face of all the evidence, it is difficult to make the case that active share, active share and past performance, shared experiences or past performance combined with a high information ratio have strong, useful, predictive value in terms of future risk-adjusted outperformance. The evidence demonstrates that investors, especially taxable investors, are best served by identifying the factors to which they want exposure and then selecting the fund(s) that provides them with exposure to those factors in a systematic, transparent, replicable and cost-effective (low cost per unit of exposure) manner.
Picture: Anne Nygård via Unsplash
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