Since the beginning of index investing over 40 years ago, the debate on active and passive equity management has raged with no end in sight. As the institutional money management industry has grown and come to represent a majority of assets, the average money manager has, unsurprisingly, been unable to beat the market, leading some investors to index their equity exposure. At the same time, there are many investors who seem to defy the odds and consistently land in the top performance deciles amongst their peers. While simple math tells us that it is impossible for the average active manager to outperform a market in which they represent a majority of the assets, we also believe most active investors make several systematic errors that doom them to mediocre long-term investment results. One of these errors is the overdiversification of their portfolios. At BBH, we believe in the value that carefully chosen active investors can add to our clients’ portfolios. As such, active share, a holdings-based metric that can be interpreted as the portion of a portfolio that differs from its index,1 is one figure we focus on to help guide us in our decision making.
The Concept of Active Share
For years researchers have strived to identify inefficiencies that can be exploited to generate superior investment performance in what, most of the time, are relatively efficient financial markets. While the majority of studies fall short of offering any useful information that will stand the test of time, more recently researchers have shifted gears and attempted to explain why the minority of funds that do outperform are successful. Among these studies, a landmark 2006 paper from the Yale International Center for Finance that coined the term “Active Share” convincingly demonstrated a glaring weakness in the U.S. mutual fund industry: overdiversified funds, or more specifically, funds with a low active share, significantly underperform their high active share counterparts.2 These overly diversified “closet index funds,” as the authors of the study call them, which are managed more for the benefit of their parent firm than the underlying investors, are one of the more notable black eyes on the fund management industry.
Research on Concentration
In the early 1980s, over 60% of mutual funds fell into the highest quintile of active share. In the five years ending in 2009, that number was closer to 25%. Why does this matter? In the most up-to-date version of the study, Petajisto (2013) finds that as a group the most active stock pickers beat their benchmarks by 1.26% per year after fees and expenses.3 The finding is strongest amongst small-cap managers but is also significant for large-cap funds. While anyone can simply purchase a small number of stocks, we believe this study shows that the decision by a mutual fund manager to concentrate purchases is often a signal of manager skill.
The biggest problem with low active share funds is that they charge fees comparable to other active managers but, because of their over-diversification, it is improbable that their performance will ever differ materially from their respective index. After calculating the active share metric across the universe of registered mutual funds, it is clear that a large portion of U.S. equity mutual funds charge active management fees for undifferentiated portfolios, and as expected, the study finds that these closet indexers as a group largely match the performance of their benchmark indices before fees and expenses. These managers’ clients are thus doomed from the start: after fees and expenses, which is what matters for clients, these funds are almost certain to underperform their benchmark indices.