There are, arguably, two ways you can go about picking a fund manager. You can do so by analysing their historic results or you can look at their portfolios and try to understand what is likely to happen or what the portfolios should deliver in the future.
The problem with analysing historic results is that it is difficult to differentiate between what a manager achieves through their own skill and what is achieved through luck. So, while this approach may tell you everything you need to know about what a manager has done, past performance – to use a phrase all fund investors should recognise instantly – is not indicative of future returns.
An alternative approach to the issue therefore is to try to understand whether or not a particular portfolio is in a position to deliver excess returns – essentially, to aim to identify in advance a fund manager who is able to count more on skill than luck – and this brings us to the concept of ‘active share’.
There is no real need to go into the exact details of the formula for active share although, if you would like to know more, you can Google Martijn Cremers and Antti Petajisto, the two finance professors who defined it. Suffice to say, active share measures how actively a fund is managed by analysing the degree to which the weightings of the fund’s holdings differ from those of its benchmark index.
Active share therefore identifies how much of a fund manager’s stockpicking activity is unique relative to their benchmark and one significant reason investors should care about that is the non-active part of the portfolio will be delivering index-like returns. Thus, if a manager has an active share of just 20%, 80% of their portfolio will be delivering investors an index-like return, which means, the active 20% will need to work very hard in order to offset the effect of the fund’s fees.
Frankly, a manager with an active share of 20% would have to be an extraordinary investor to be able to generate that level of outperformance while, conversely, a manager with an active share of 80% should, providing they are a good stockpicker, find it a whole lot easier to generate enough outperformance to offset the effect of fees.
It would seem reasonable to conclude therefore that active share – in the hands of a good stockpicker – is exactly what investors should be looking for and yet that task has been growing tougher and tougher. Figures from the US, for example, show the percentage of total assets under management there with an active share of less than 60% has risen from 1.5% in 1980 to more than 40% today.
A lot of fund managers these days are thus either ‘closet’ index-trackers or if their active share is sufficiently low they will struggle to outperform their benchmark index net of fees. Furthermore, a growing number of investors are comfortable with this because they are more interested in minimising the chance of their fund falling more than the index than they are on the possibility of it outperforming.
Still, if you do not number among such a group, you should seek out a good stockpicking manager with high active share – otherwise the odds are your chosen fund’s performance will not be enough to give you a decent return once fees are taken into account.