The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. While active share may have worked prior to 2002, these results show that even the highest quintile of active share funds produced negative alphas in the post-2002 period. In other words, as markets have become more efficient over time, the alpha was “gone with the wind.” The most recent contribution to the literature on active share is Vanguard’s July 2019 paper, “The Urban Legends of Active Share.” Their database covered actively managed U.S. open-end equity mutual funds over the 15-year period 2004-2018, including liquidated and merged funds. The following is a summary of their findings:
- On average, low-cost, low-active-share funds—part of the category of “closet index funds”—outperform high active-share funds.
- There is a significant positive relationship between active share and expense ratios. Funds with higher active share tend to charge more: It is this relationship that leads to a negative relationship between active share and net excess return. Thus, what you pay per unit of active share is important.
- Active share is not a compensated risk premium—it leads to a wider dispersion of outcomes without a corresponding increase in average returns.
SummaryThe bottom line is that in the face of all the evidence, it is difficult to make the case that active share as a stand-alone characteristic has any predictive value in terms of future risk-adjusted outperformance. We do believe that active share provides value to investors when they are investigating factor-based investment vehicles that are measured against a passive market benchmark. Despite this limited use, active share seems to be becoming an increasingly popular metric both in terms of reporting and evaluation. Given the evidence, there doesn’t seem to be a logical explanation for the phenomenon other than a high active share is a necessary ingredient for outperformance. Unfortunately, it’s not a sufficient one, or as Tommi Johnsen, Ph.D. put it in her blog post: “No Skill, Well, Active Share Won’t Save You!” 1
FootnoteThere’s one more important point we should cover.
It’s Not Only About AlphaInvestors may want to own a fund that provides exposure to factors they care about, such as market beta, size, value, and momentum. They should then be happy to have minimal alpha as long as they get the beta (loading on a factor) they are seeking, which leads to higher returns. In other words, such investors should rather own a low-cost, passively managed small value fund that provides high loadings on those factors and minimizes or even eliminates negative exposure to momentum (typical of value funds) and has no alpha as compared to an active fund with less exposure to those factors even if it generates positive alpha. The active funds positive alpha would have to be great enough to overcome the loss of returns due to the lower loading on the factors (Beta’s), as well as higher fee structures. To illustrate this point, consider the following example. We’ll compare the returns, loadings on factors, and alphas for two funds from the same asset class (U.S. large value): the actively managed Vanguard Equity Income Fund (VEIPX) and the passively managed DFA U.S. Large-Cap Value III Portfolio (DFUVX). (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.) The data is for the longest period we have available, March 1995 through April 2019. The factor loadings and returns come from Portfolio Visualizer and use the Fama-French benchmark factors and the three-factor model, while the factor premiums are from Ken French’s data library.
VEIPX DFUVX Annual Factor Premium Market Beta 0.80 1.08 8.4 Size -0.21 -0.05 1.6 Value 0.36 0.59 1.6 R-Squared 0.90 0.92 NA Annual Alpha 1.14 -0.68 NA Annualized Return 10.0 10.5 NA
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. First, observe that the r-squared figures are high, indicating that the model is doing a good job of explaining returns. Second, as you can see, while VEIPX produced a positive annual alpha of 1.14 percent and DFUVX produced a negative alpha of -0.68 percent (a difference of 1.82 percentage points), DFUVX provided a 0.5 percentage point higher return. The reason for the out-performance is clear. DFUVX had much higher loadings on factors that delivered premiums. This allowed DFUVX to overcome the 1.82 percentage point difference in alpha. While alpha is nice, you only get to spend returns. Thus, it’s important to consider all of these issues, including turnover, expense ratios and loading on factors. ↩