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Recently, a fund house reported that it will disclose the active share of its mutual fund schemes every day. It also claimed that active funds underperform the index because the average manager owns too many stocks and, in effect, tracks the index. So, what is active share, and how should investors interpret the metric?

Active share is defined as the proportion of fund, based on stock weights, that is different to the benchmark. An index fund that tracks the benchmark perfectly would have an active share of zero, and an active fund that has no overlapping stocks with the benchmark would have an active share of one, and everything else in between.

Asset owners and trustees insisted on minimum active share as a criterion for manager selection. An international study found that in those markets where passive investing was growing rapidly, not only did the fees for active management fall, but the active funds responded by becoming more active, or increasing their active share.

Is active share, then, the holy grail of investing? Active share is a measure of active risk, and taking on more risk is unlikely, by itself, to lead to outperformance. Active management requires a combination of skill, opportunity and conviction. Let’s consider each in turn. Active managers effectively make alpha forecasts, though couched in terms such as price targets. The truth is, no one gets it right all the time. Therefore, theory (and intuition) suggests that the manager’s value added per unit of risk—the information ratio—is a function of the proportion of forecasts she gets right, and the breadth of the forecasts (a function of opportunity). Therefore, to add value, the active manager must get her limited number of predictions absolutely right; in other words, a highly skilled manager can, and must, have a high active share. But she could also access many opportunities. In practice, small-cap managers tend to have high active share than large-cap managers. Small-caps are not only broader than large-caps in terms of number of companies, but also more informationally inefficient. This makes it easier for managers with modest skills to access several opportunities and hold positions far above the stocks’ weight in the benchmark.

The final aspect, conviction, means holding on to the winners rather than selling them too early, and making prudent decisions about the losers. Studies have demonstrated that funds that have active share and long holding periods outperform those that don’t. It is easy to see why: Fund managers who frequently trade lack conviction, or worse, may be window dressing their portfolios to show high active shares during reporting periods.

How should investors evaluate active share? Past performance is a poor predictor of skill; good managers can go through periods of underperformance owing to circumstances outside their control; and taxes and transaction costs mean it is often costly to replace funds. Investors (or hopefully their advisers) make their own alpha forecasts when they choose fund managers, just as managers about stocks. Assuming they believe markets are inefficient and good active managers exist, they should be willing to make the effort to identify them. Otherwise, they should stick to low-cost index funds. However, to select active funds merely based on active share or any other fancy metric is asking for trouble.

Does that mean active share has no value? No. Active share is a simple metric to communicate, and may convey additional information over similar measures such as tracking error. It is most useful to evaluate the level of fees—if an active fund hews closely to benchmark and delivers benchmark-like returns, it should charge benchmark-like fees. Active share may be one of the several measures for the degree of portfolio “activity".

It is a useful metric that funds should start reporting regularly. But beware Goodhart’s law—when a measure becomes a target, it ceases to be a good measure.

Sivananth Ramachandran is a chartered financial analyst and director of Capital Markets Policy (India) CFA Institute.

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