The Active Share Debate: AQR versus the Academics

/The Active Share Debate: AQR versus the Academics

The Active Share Debate: AQR versus the Academics

By | 2017-08-18T16:55:47+00:00 September 21st, 2015|Research Insights|7 Comments

There is an interesting discussion in the geeky world of academic finance literature between the intellectual muscle at AQR and academia.

aqr versus the academics on active share

The discussion revolves around the following question: “Does Active Share matter?” This is an important topic for active ETFs and Mutual Funds in the marketplace.

The original paper on this measure was written by Cremers and Petajisto and was published in the Review of Financial Studies in 2009 (top finance journal). Links to the paper can be found here and here. The abstract of the paper is the following:

We introduce a new measure of active portfolio management, Active Share, which represents the share of portfolio holdings that differ from the benchmark index holdings. We compute Active Share for domestic equity mutual funds from 1980 to 2003. We relate Active Share to fund characteristics such as size, expenses, and turnover in the cross-section, and we also examine its evolution over time. 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. Nonindex funds with the lowest Active Share underperform their benchmarks.

Main Finding of the paper: For non-index funds, the higher the active share, the better the performance. We tend to agree, as we have talked about diworsification in the past. However, just because a manager creates a more active portfolio (a necessary condition for outperformance), this doesn’t imply an active manager will actually have outperformance. The team at AQR (Frazzini, Friedman, and Pomorski), in a forthcoming article in the Financial Analyst Journal (link to the paper is here), address this question.  The abstract is the following:

We investigate Active Share, a measure meant to determine the level of active management in investment portfolios. Using the same sample as Cremers and Petajisto (2009) and Petajisto (2013) we find that Active Share correlates with benchmark returns, but does not predict actual fund returns; within individual benchmarks, it is as likely to correlate positively with performance as it is to correlate negatively. Our findings do not support an emphasis on Active Share as a manager selection tool or an appropriate guideline for institutional portfolios.

Main point of the paper: Active share should not be used as a manager selection tool. Basically, for a given index, they find that active share cannot be used as a reliable tool to identify out-performance.

So is Active Share a waste of time?

As Lee Corso says every Saturday morning during College Gameday, “Not so fast!”

The two authors of the original paper, Martijn Cremers and Antti Petajisto were quick to shoot down the AQR findings.

Here is the executive summary from Antti Petajisto:

All of the key claims of AQR’s paper were already addressed in the two cited Active Share papers: Petajisto (2013) and Cremers and Petajisto (2009).

1) The fact about the level of Active Share varying across benchmarks has been widely known for many years. Its performance impact was explicitly studied and discussed in the first drafts of Petajisto (2013) back in 2010, and the performance results remained broadly similar. The reason for the apparent discrepancy is AQR’s choice of summarizing results by benchmark, which effectively gives the same weight to the most popular index (S&P 500, assigned to 870 funds) and the least popular index (Russell 3000 Growth, assigned to 24 funds), which is not sensible as a statistical approach.

2) The issue about four-factor alphas varying across benchmark indices does nothing to change the fact that higher Active Share managers have been able to beat their benchmark indices. However, it does raise an interesting point about the four-factor approach to measuring performance, and in fact my coauthors and I wrote a long and detailed paper about this exact issue first in 2007 (published later as Cremers, Petajisto, and Zitzewitz (2013)).

3) AQR’s researchers argue that there is no theory behind Active Share and they remain mystified by the differences between Active Share and tracking error. It is unfortunate that they have entirely missed the lengthy sections of both Active Share papers that discuss this exact topic: pages 74-77 in Petajisto (2013) and sections 1.3, 3.1, and 4.1 in Cremers and Petajisto (2009). The short answer is that Active Share is more about stock selection, whereas tracking error is more about exposure to systematic risk factors. So clearly ignoring large and essential parts of the original Active Share papers is simply not the way to conduct impartial scientific inquiry.

If that executive summary wasn’t scathing enough, Martijn Cremers actually wrote a paper titeld “AQR in Wonderland: Down the Rabbit Hole of ‘Deactivating Active Share’ (and Back Out Again?)

Here is the abstract:

The April 2015 paper “Deactivating Active Share”, released by AQR Capital Management, aims to debunk the claim that Active Share (a measure of active management) predicts investment performance. The claim of the AQR paper is that “neither theory nor data justify the expectation that Active Share might help investors improve their returns,” arguing that previous results are “entirely driven by the strong correlation between Active Share and the benchmark type.”

This paper’s first and main aim is to establish that the AQR paper should not be interpreted using typical academic standards. Instead, our conjecture is that this AQR paper falls into a wonderfully creative but altogether different genre, which we label the Wonderland Genre, as its main characteristic seems to be “Sentence First, Verdict Later.” For example, the results in the AQR-WP cannot be taken at face value, as the information that is not shared reverses their main conclusion.

Secondarily, we consider the plausible claim that benchmark styles matter and find that controlling for the main benchmark style, the predictability of Active Share is robust. While Active Share is only one tool among many to analyze investment funds and needs to be carefully interpreted for each fund individually, Active Share may indeed plausibly help investors improve their returns.

Thirdly and finally, we impolitely consider why AQR may not be a big fan of Active Share by taking a look at the AQR mutual funds offered to retail investors. We find that these tend to have relatively low Active Shares, have shown little outperformance to date (with performance data ending in 2014) and thus seem fairly expensive given the amount of differentiation they offer.

So who is the winner in the debate?

The answer is both are probably correct at some level. More concentration (less diworsification) probably has higher active share and in the past had higher returns. However, one cannot just take any random selection of stocks and expect to outperform (we show this here), the style of the investment matters, which was AQR’s argument (we prefer Value and Momentum).

Let us know what you think!



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About the Author:

Jack Vogel
Jack Vogel, Ph.D., conducts research in empirical asset pricing and behavioral finance, and is a co-author of DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His dissertation investigates how behavioral biases affect the value anomaly. His academic background includes experience as an instructor and research assistant at Drexel University in both the Finance and Mathematics departments, as well as a Finance instructor at Villanova University. Dr. Vogel is currently a Managing Member of Alpha Architect, LLC, an SEC-Registered Investment Advisor, where he heads the research department and serves as the Chief Financial Officer. He has a PhD in Finance and a MS in Mathematics from Drexel University, and graduated summa cum laude with a BS in Mathematics and Education from The University of Scranton.
  • Mark

    Active Share is certainly not a crystal ball. Theoretically speaking, I disagree that high active share is a necessary condition for outperformance. As pointed out in the AQR paper, if you can avoid the holding that has the worst performance for S&P 500, you can still outperform the market. Of Course, that is assumed you have the perfect foresight, which is I think it’s not a necessary condition.

    In terms of thoughts on how to use active share, it is a useful tool for sure, but can not be used alone when it comes to fund selection. It has to be used in conjunction with others factors, such as investment process, philosophy.

  • Jack Vogel, PhD

    I agree, both sides are probably right at some level.

  • Hey Mark,

    Good points.

    You can certainly outperform, but you need some degree of active share to beat the market–not gonna work if you are the market. And the capability to outperform is going to be somewhat related to how different you are than an index. But to your most important point, you need a process that doesn’t suck. For example, holding a concentrated portfolio of low momentum low-quality expensive stocks has high active share, but low expected performance! ha!

  • The papers from Petajisto et al. caused quite a stir among the more thoughtful selectors of active managers. I am not sure they are telling us anything surprising. It is well established that alternative weighting methodologies tend to outperform cap-weighted indices (see for example this paper from Cass Business School, section 7, page 22 ). The chaps from Research Affiliates have argued ( ) that this is the result of their value and small-cap exposures (they do not seem to be capturing momentum, and low-volatility investing looks like a somewhat separate effect).

    Practical take-away for the wealth manager: going off index leads to outperformance on average. But you don’t have to use an active manager to do that. Since they are more expensive and less reliable, why bother?

  • Mark

    One thing I dont understand for AQR funds is that why they want to have over 300/ 400 holdings for an equity style. I certainly understand the importance of diversification, but having a 300-holding portfolio does not seem to appeal for me.

    If R1K is used to approximated the US Large cap, does not that mean 100 holdings (one decile) are good enough to harvest a certain risk premium? The only reason I can think of for this many holdings is business/career risk. However, if you dont want to take those risk, how come you can expect investors to pay for an active management fees. The good thing is that the cost for their funds is not too bad.

  • career risk drives the portfolio formation decision…more names, less career risk, fewer names, higher career risk