Active share shines light on funds’ alpha potential

Actively managed equity funds have been besieged for years by cheaper index funds, but a newly popular metric might give them a chance to turn the tide.
For much of the past decade, investors have shown a clear preference for index funds, particularly in the aftermath of the financial crisis. Since 2003, passively managed equity mutual funds and exchange-traded funds have taken in more than $1 trillion in net inflows, while a net $287 billion has been pulled out of actively managed equity funds, according to Lipper Inc.
At the heart of the switch has been active managers’ struggle to beat their benchmarks, accounting for fees. For example, only one-quarter of all domestic large-cap-equity mutual funds beat their benchmarks over the five-year period through 2012, according to Standard & Poor’s.
“There’s been such an exodus from active strategies toward ETFs. Active management isn’t all bad all the time,” said Chris Wolfe, chief investment officer for Merrill Lynch Wealth Management’s Private Banking & Investment Group.
VALUE PROPOSITION
The shift has left actively managed fund companies and the advisers who love them searching for a way to re-establish their value proposition to investors. Some think they may have found the answer — or at least part of it — in active share.
Active share, a concept first highlighted by a pair of finance professors at the Yale School of Management in 2006, is a measure of how different a mutual fund’s portfolio is from its benchmark index. The higher the active share, the less a fund looks like its benchmark — and therefore the less likely it is to produce benchmark- or index-mimicking returns after fees.
Index funds “are making up more and more of the core portion of a portfolio,” said Paul Justice, director of fund research methodology at Morningstar Inc. “But investors are still seeking out managers that can add value. They want managers who will really make some active bets.”
Mr. Wolfe is one such adviser — he likes to combine mutual funds with high active share and index funds within a portfolio.
“In a lot of cases, using index funds as the core and active managers as satellites works very, very well,” he said. “We use active share as a way to evaluate managers, and use it in a way to calibrate the risks we see managers taking. We’re using it more and more as a way to align what we see in the manager process with the position they’re taking.”
RISK MEASURE
Some fund companies have made active share a priority. At Goldman Sachs Asset Management, for example, Steven Barry, chief investment officer of fundamental equity, receives daily risk reports from the company’s equity funds that include, among other measurements, active share.
“We’re reluctant to say it’s the Rosetta stone of investing, but it’s a precondition for managers to be able to beat their benchmark,” Mr. Barry said. “We need to be different enough and right on those decisions to earn that excess return.”
Some advisers are concerned about what would happen if mutual funds with high active share started getting a lot of attention.
“When everyone starts using active share, you’re going to find more funds that have active share than in the past,” said Rick Ferri, founder of Portfolio Solutions LLC. “It’s the next derivative of the way advisers are going to try to find managers who will outperform. Fund companies will find a way to game the system if it gets popular.”
Mr. Justice cautions advisers not to have too much faith in funds with high active share.
“It certainly indicates the performance is going to be different [than the benchmark], but it’s not going to tell you whether or not that difference is going to be positive,” he said.
In fact, while high active share can lead to big returns, it can also lead to big losses.
A case in point: Bruce Berk¬owitz’s Fairholme Fund (FAIRX), which had an active share of 98% as of the end of the first quarter, a reflection of his propensity for concentrated bets. In 2012 it trounced the S&P 500 by 1,900 basis points, and in 2010, it beat it by 1,000 basis points.
In 2011, however, it fell 32%, which is nearly what the S&P 500 lost during the financial crisis.
“It’s a helpful calculation,” Mr. Justice said. “In and of itself, it only gets you so far, but you can find managers who really dance to the beat of their own drum.”
The moral of the story is to make sure it’s a beat you can keep over an extended period of time.

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