In their paper, Martijn Cremers and Antti Petajisto start with the hypothesis that the more active the fund, the higher its average gross return (before fees and expenses). The researchers developed a measurement they call Active Share, which measures “the fraction of the portfolio that is different from the index.”
The authors note the average fund loses to its benchmark index by 0.33% per year. According to Cremers and Petajisto, the traditionally used measurement of tracking error does not help much when picking funds since their analysis across all tracking error quintiles showed consistently negative benchmark-adjusted returns and alphas.
However, the researchers’ measurement of Active Share does help when picking funds. The difference in benchmark-adjusted return between the highest and lowest Active Share quintiles is 2.81% per year, according to the study paper.
Further, investors should choose funds in the highest Active Share quintile, the researchers said, since funds in the highest Active Share quintile beat their benchmarks by 1.39%. Funds with the lowest Active Share essentially had performance equal to their benchmarks.
When combined with tracking error, the study found that more actively managed funds performed better regardless of tracking error, with high Active share/high tracking error funds performing best.
Additionally, when controlling for size, the study found Active Share was directly related to better performance. Excluding the largest 40% of funds, the highest Active Share funds’ stock picks outperformed their benchmarks by about 2-4% per year. The more actively managed funds in the largest 40% also outperformed their benchmarks, but the researchers concluded the results were not statistically significant.
The researchers noted that prior studies have shown the average fund slightly outperforms the market before expenses and underperforms after expenses. They conclude from their study that funds with the highest Active Share significantly outperform their benchmarks both before and after expenses, while funds with the lowest Active Share underperform after expenses.
The study “How Active is Your Fund Manager? A New Measure That Predicts Performance” is here .