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Active funds may be hand-picked by humans, but many don’t contain stock selections that differ much from their benchmarks.
A fund manager’s career may be at risk if they underperform against their benchmark, so unsurprisingly they might be motivated to play it safe.
Funds run like this are more likely to perform in line with their benchmark rather than underperform significantly. However, the flip side is that they are less likely to outperform much either. Such funds are known as closet trackers or closet indexers.
If closet trackers bear the higher fees usually associated with active funds, but with little prospect of outperforming their benchmarks by much, arguably they represent the worst of both worlds.
Only some active funds have the conviction to pick stocks that vary considerably from their benchmark. This isn’t automatically a good thing. After all, it means the fund has greater capacity to underperform - as well as outperform - the benchmark.
Funds with a high Active Share are those that differ most from their benchmarks.
A passive index fund that exactly mirrors its benchmark index would have an Active Share of 0%, while a fund that holds absolutely no stocks that are in its benchmark would have an Active Share of 100%.
The concept was developed by Yale professors Martijn Cremers and Antti Petajisto in 2007, who defined funds with an Active Share of 20-60% as a “closet indexers” and those with a lower Active Share as a “passive manager”.
Those with an Active Share above 80% are picking stocks that differ a great deal from their index. Some research suggests these most active funds (as a group) do better than average, but the point remains contested.
There’s also another measure – tracking error – which looks at the same issue in a slightly different way.
It’s important to be aware that high Active Share isn’t automatically ‘good’ either. Picking stocks simply because they don’t feature in the benchmark wouldn’t be much of an investment strategy, after all, but it would produce a high Active Share. Also, it could just indicate that the fund has selected an unsuitable benchmark. So assessing a fund on Active Share alone isn’t recommended.
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Merryn Somerset Webb debates Active Share with readers