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Martijn Cremers on What's Important About Active Share

By Martijn Cremers, PhD, Timothy D. Paulin, CFA
Active Investing
Share:
What’s Important About Active Share – Martijn Cremers Interview

In This Video
00:00 - Introduction
00:06 - Chapter 1: Background of Active Share Research
06:40 - Chapter 2: Pitfalls of How Advisors & Investors Apply Active Share
12:55 - Chapter 3: Three Pillars of Active Management
19:12 - Chapter 4: Evolving Fiduciary Environment

Chapter 1: Background of Active Share Research

TIM:
I’m Tim Paulin, head of research and product (development) at Touchstone Investments. I’m joined today by Martijn Cremers. Martijn is the Martijn J. Gillen Dean and Bernard J. Hank Professor of Finance, at the University of Notre Dame’s, Mendoza College of Business. Martijn has become well known over the course of the past decade, based on his pioneering  research, in the area of active management and Martijn, what I would like to do first of all, is to talk to you a little bit about, that original research that you’ve done, in active management. We believe that there are, despite some debate in the investment community about its purpose and use, there are things about it that are inherently valuable. So could you give us a little background about that original work?

MARTIJN:
Yes, thanks for having me. Active Share, is a simple measure of active management. It measures how different the holdings of the funds are, relative to its benchmark. It’s very literal. It’s the Active Share; so it’s the Share: a portion of the holdings that are different from the passive benchmark, that are active. So, Active Share, simply tells you how different the holdings are; how much stock picking the manager is doing. If you buy a fund with a high active share, it means that you buy a fund, that has very little overlap with passive benchmark index, that you generally can get for very low expenses.

TIM:
Martijn, in your research, you suggest that there are different thresholds, for the types of strategies that we would consider to be active, or those that might be inactive, or even closet indexers. Can you expand on that a bit, and tell us what the implications are, for investors.

MARTIJN:
Yes, in general, if you’re looking for a fund manager that is really a fundamental stock picker, you’re looking for a high active share. So, 60% or below, we identify as not very active. Those fund(s), should also then, be very inexpensive, because if you have a fund with low active shares, say below 60%, then those funds have large substantially large overlaps with the benchmark. Those overlapping holdings, in the benchmark, are available at (a) very low cost right through some index funds. So, high active share, indicates very different holdings in benchmark. What is high also depends on the investment universe. So, for example:  Large Cap Funds, tend to have lower active shares, and Smaller and Mid Cap Funds, tend to have higher active shares. If you think about the top quintile of funds, in terms of active share, then the top quintile for large cap funds, would be active share of 80% or so, and higher. For mid cap funds, (the) top quintile would be 90% (or so), or higher, and for small cap, may be (might) be 95% (or so) and higher. So, what high active share is, is to some extent, depending on the investment universe you are looking at.

TIM:
So, as investors and investment practitioners, we need to change our bars, with respect, to what we consider to be truly active?

MARTIJN:
Yes, exactly.

TIM:
Thank you.

TIM:
So, Martijn, in your research, you’ve indicated that there are different thresholds, for what we might consider to be truly active. Even thresholds, if we reverse them, that might indicate what funds might actually be closet indexers. I wonder, what the implications are for investors, if the threshold for whether a fund is active or not, changes by the investment universe.

MARTIJN:
Yeah, good question. In general, if you’re looking for an individual stock picker, you’re looking for a manager with a high active share. What is high active share, depends on the type of securities, that the manager, has selected for the portfolio. If you have a low active share, that means you have a large substantial overlap, with the benchmark. Low active share, I would say, is anything 60% and lower. There’s no problem with that, but those funds should also, then be very inexpensive. High active share, depends on the investment universe. For example: Large Cap Funds, tend to have lower active shares, than Mid and Small Cap Funds. So, if you think of truly active funds as being in the top quintile (the top 20% in terms of active shares within their category), then for Large Cap Funds, that would mean, an active share of 80% or so, or higher. For Mid Cap Funds, you are looking at a threshold of about 90%, and for Small Cap, you are looking at top quintile being about 95% active share, or higher.

TIM:
One of the things you’ve mentioned, was that if funds have active share(s) less than 60%, they should also be inexpensive. Can you expand on that some?

MARTIJN:
Yes, so, if you have funds with an active share, let’s say in the 60s (or below), then those funds, have substantial overlap with the benchmark index. While, the benchmark index holdings are available, at very low cost. So, by extension, funds that look very much like the benchmark; and they should also be inexpensive, because so, much of their holdings are the same. So, their out-performance, (what you really pay the fees for), that can only be driven by the portfolio, that is different. So, if you have similar holdings, you’re going to get a similar performance. If you want to outperform, if you want to earn your fees back, you need active share; and if you have low active share, it’s going to be very hard for the manager to do that. Because so much of the portfolio is the same and that’s not going to generate different performance.

TIM:
Interesting. I think about that concept sometimes. We talk to advisors and investors to change the lens a bit from, is this a cheap active manager, to, is it possibly an expensive passive manager. Or is it somewhere in between?

MARTIJN:
No, exactly. So, the low active share manager, is in my mind, is a manager who only partly, actively, manages the portfolio. I think, of a low active share manager, as a manager, where part of the portfolio is really passively managed, and the other part of the portfolio, is actively managed. And, you only want to pay fees, for the part that is actively managed.

Chapter 2: Pitfalls of How Advisors & Investors Apply Active Share

TIM:
So, Martijn, we found some pitfalls in how advisors and investors, are applying active share into their due-diligence efforts. Can you share some of the pitfalls, you’ve seen in application of active share?

MARTIJN:
Sure. I think of active share as a starting point. If you’re looking for a manager that does a lot of individual stock picking, I’d look for a manager with high active share. And again, that’s just a starting point. Another important thing, is that active share does not measure skill. Active share, simply measures how different the holdings are. It does not measure the skill, with which, those holdings that are different are chosen. And finally, active share is relative to a benchmark. So, if you have an active share that is relative to a particular benchmark for the fund, if that benchmark is not the right benchmark for the fund, then the active share number is not the right active share number either.

TIM:
Martijn, I’d like to build on pitfalls you just talked about for a minute. Let’s start with benchmark relevance. What we found is when advisors that we work with go to your website: activeshare.info and pull up the active share for a particular fund, sometimes they may get a false sense of confidence, based on a high number that they see, for a particular strategy. What are some of the issues around benchmark relevance, that we need to be aware of?

MARTIJN:
So, you want to make sure that the benchmark that is in the prospectus for the fund, is the right benchmark for that fund. We find in our research, that this is the case for about 75% of funds. But for 25% of funds, we find that there is another benchmark that actually is more appropriate. So, if you go to the website, we show the active share with respect to, two different benchmarks for funds. One, is for the prospective benchmark, but the other one is for what we call the minimum active share benchmark. If those two are different, (if those two benchmarks are economically quite different) then that’s an indication for us, that the prospective benchmark may not be the right benchmark for the fund. In that case, investors should be careful, in interpreting the active share with respect to the prospective benchmark, and they should also consider, the active share with respect to the minimum active share benchmark.

TIM:
So, one of the ways I would think about, an example, for a practitioner would be, if they had invested in the fund, with the objective of obtaining Mid Cap exposure and that fund has a prospectus benchmark of the Russell Mid Cap Index. If they find that the best benchmark, the minimum active share benchmark, for that strategy was a Large Cap Index, it might suggest two things. Number one, they’re not getting the exposure that they’re looking for, and number two, that the false sense of security (they got about high active share relative to the Mid Cap benchmark), might not be justified.  Is that, an accurate way of thinking?

MARTIJN:
Yes, no exactly. What we found in our research is that for those funds, where the benchmark in the prospectus is not the best benchmark, that the minimum active share benchmark which we think is a better benchmark, is generally more risky. So, what this also suggests, is if you simply compare the funds to its prospective benchmark, (which for this group of funds may not be the best benchmark), you are also comparing the funds to a benchmark that is relatively less risky.  So, you’ve also got the sense that you may be underestimating the risk, in the fund. By comparing it to a benchmark, that is not the best fit, but is also less risky than the fund actually is.

TIM:
Martijn, I want to build on one of the pitfalls that you mentioned around the concept of skill, because naturally investors aren’t simply looking for something that’s active, that’s different than a benchmark. They also want to know is this a manager that’s going to help me achieve my goals. So, how do you think about the concept of skill, related to this concept of active share?

MARTIJN:
So, active share is not a measure of skill, but I still think, it’s related to skill. Now skill, ultimately means, that the manager can outperform in the long term. What we found in our research is that managers with low active shares, especially those that are not inexpensive, substantially underperformed, on average in the long term. A manager with high active share did not underperform. I also think, that if you have a manager with strong long term outperformance, achieved through a high active share with a strategy that requires a certain courage of the manager’s convictions; that really suggests the manager has skill. So, skill is outperformance.  And if active share is related to skill, then a key test for that is the combination of being high active share manager and having good long term past performance. The key test for skill is performance persistence in the long term. That is, what we found in our research. So, when we look across high active share managers and from those we look at those who also have strong long term past outperformance, then we see substantial performance persistence. Those managers that currently have high active share also had strong past outperformance that those managers on average stand to outperform substantially also in the future. That for us is evidence that active share is related to skill.

TIM:
So, you talk about past performance, outperformance, performance persistence. Those are general ways of doing things when it comes to evaluating skill. And what I’m hearing from you is, avoidance of any very specific measures, to say this is how you should absolutely measure skill. Is that an accurate way of thinking about it?

MARTIJN:
Yes, so, investors will all have their own ways of evaluating performance. In practice, I think most investors compared the performance of the funds, to the performance, of the benchmark.  Which, I actually think is fine, as long as you have the right benchmark.

Chapter 3: Three Pillars of Active Management

TIM:
Martijn, in 2017 the Financial Analyst Journal published your paper about the three pillars of active management. One of those pillars is skill. The other two are conviction and opportunity. Tell us about how those three things relate to each other.

MARTIJN:
So, the framework of the three pillars of active management are skill, conviction and opportunity. In the 2017 article, I make the case that active managers who can outperform the long term really need all three. They need skill, but they also need to apply that skill in a strategy, that requires the courage of the manager’s convictions.  Without that, what prevents too much money flowing into the strategy, what prevents others from doing the same thing? If there are not these economic frictions, barriers for entry if you like. And while we think about those barriers to entry is a strategy that requires the courage of the manager’s convictions. And third the manager needs opportunity. I think of internal and external constraints that may limit the opportunity of the manager. External constraints is opportunity in the market place and internal constraints would be restrictions put on the manager internally by tracking error constraints. The manager has too many constraints internal and external, then even if the manager skill and conviction the manager won’t be able to actually execute.

TIM:
So, Martijn, along those lines, we are often asked for an example. A situation where one of those elements may not be present. The example I often give would be:  consider a situation where you find that you have a manager with a long record of outperformance so, they feel confident that they’re skilled. They find a high active share. They find a portfolio that evidences his conviction. So, they feel like this manager does have the courage of their convictions. But then either because of external forces or the manager’s own decisions we find opportunity may be constrained. You mentioned tracking error and limiting tracking error. If we tell some manager we want you to act with a tight tracking error to a benchmark but we want you to be highly active that can be very difficult to achieve. The other element that might constrain opportunity is size. We see a lot of successful managers with very good performance that grow to enormous asset sizes. Can you talk a little bit about how that kind of constraint on opportunity can impact results?

MARTIJN:
Yes, if the fund grows in size a lot then the active share tends to go down. And our research suggests that those types of funds with very strong outperformance that was achieved generally through a high active share strategy have to become very large they perhaps become too large. Active shares go down and then their past outperformance does not persist.

TIM:
So, Martijn, the three pillars of active management skill, conviction and opportunity are preconditions, to outperformance over time.  I wonder if you could dive a bit deeper into the area of conviction.

MARTIJN:
Sure. Let me give an example of a strategy that I think requires the courage of one’s convictions. That is patience. Most patient capital think of managers who own stocks for two years or three years or longer. Most patient capital is not very actively managed. Most active managers are not very patient. That’s because the combination of being an active manager with a high active share and implementing a patient approach is very difficult. Or it’s difficult to be patient in an impatient world. There is a mismatch for those funds. Between the holding periods of the manager, say three years, and the period over which the performance of those managers is evaluated by the investors.  Which is generally much shorter than that. That mismatch creates risk for the manager. It creates a real challenge.  Therefore it is hard to do and as a result, I think, managers who are able to do it are able to benefit from opportunity in the markets that require long holding periods, and substantially outperform. Because it’s hard to do, there’s few managers who actually combine the high active share strategy with the patient approach and those few managers who are able to do it have substantially outperformed. And we documented that in a paper we published a couple of years ago entitled “Patient Capital Outperformance”.

TIM:
Excellent. One of the things I think about with respect to active managers is, we often refer to active managers as stock pickers. But essentially they’re company pickers, right? They’re trying to identify a small set of companies that will create outperformance, will create additional capital over longer periods of time and that’s often a different way for investors to think about what am I really trying to achieve. Am I investing in a market am I investing in an exchange. Am I investing in a factor? At the end of the day no matter what combination you’re investing in, you’re investing in a set of companies. And what we are trying to find is long term outperformance and what people get hung up in sometimes is what happened this past quarter, what going to happen with the next quarterly report. And it takes away from their concept of what really drives long term outperformance which is the performance of those fundamentals of those underlying companies.

MARTIJN:
Yes if you think about the high active share manager with a patient strategy I think those managers tend to think like owners. They invest in those companies thinking like owners. So, they place a bet, not just on the company or the industry or the markets in general, but they really place a bet on the whole management team and so, they think like owners, they think long term.

Chapter 4: Evolving Fiduciary Environment

TIM:
Martijn, one of the things we are seeing over the course of the past several years in particular an evolving fiduciary environment for financial professionals. Is a big focus on expenses? What is the cost of my investment or what’s the cost of my particular active strategy? You have a more nuanced approach to evaluating costs of active strategies. Tell us about that.

MARTIJN:
Yes, I argue that how much you pay for funds should be related to the active share. So, for low active share funds the fee should be low. For a higher active share fund it’s more natural I think that the fees will be higher. A simple way to think about this is to take the ratio of the expenses divided by the active share. That kind of assumes that you can invest in the benchmark or the index fund for very, very low or no expenses and then you’re really only paying the expense ratio the expenses for the active part of the portfolio. The active part is different from the benchmark the active share of the portfolio. This ratio the expenses over the active share is what we call active fee. So, it gives you a sense again the active fee of how much you’re paying for the active part of the portfolio.

TIM:
Is it fair to suggest that the active fee is somewhat of a hurdle rate because it’s proportion by which the active part of the portfolio has to outperform in order for the entire fund to beat the benchmark?

MARTIJN:
Yes, exactly. So, what you see then is for the low active share funds that are not inexpensive their active fees are going to be pretty high and those managers have substantial hurdle rates to outperform. And the active fee for high active managers may actually be lower than the active fee for low active share managers for that exact reason.

TIM:
One of the interesting things is you’ve done all this research. Advisors and investors are used to going to certain places to evaluate the funds, active funds in particular. Where can investors find more information about the three pillars of active management, patience, active fee, etc.?

MARTIJN:
Well you can go to my website: activeshare.info. The website activeshare.info gives information of U.S. equity funds that are in my sample that I used for my academic studies. So, it gives you the active share with respect to the prospective benchmark. It gives you the active share with the respect to minimum active share benchmark. It gives you a sense of where the holdings are in terms of what percent of the holdings is also part of the benchmark. What other part of the holdings is not part of the benchmark. It tells you the holding duration of the assets currently in the fund. It also calculates the active fee and so, it gives you a lot of information that is available for free on activeshare.info all the things that we talked about today.

TIM:
Martijn, your most recent paper is essentially a compendium of academic research on active management. What did you find as you evaluated twenty years of active management research?

MARTIJN:
Our most recent publication, published in the Financial Analyst Journal, very recently is a survey article where we look at over two hundred academic papers on active management. So, the informal tag line of the paper is “We read two hundred academic articles so, that you don’t have to”. The title of the paper kind of sums it up. Challenging the conventional wisdom of active management. So, the conventional wisdom right now I think is based on the research that was done in the 80s and 90s. The conventional wisdom says that it’s very, very difficult to find active managers that outperform. So, we surveyed the last twenty years of academic papers on active management and we find that this literature gives many examples of studies that suggest the opposite. So, that’s why we think the actual academic literature of the last twenty years really challenges this notion and makes the case I think for much more positive assessments of the value of active management.

TIM:
Again, I’m Tim Paulin with Touchstone Investments. I’d like to wrap up by thanking Martijn Cremers for being with us here today. Any last words you would like to impart?

MARTIJN:
Well thank you for having me. And for more information on active share and other elements of my research you can go to activeshare.info. Thank you!

TIM:
Thank you Martijn.

Learn more about Martijn Cremers' Active Share research.


This material is offered by Touchstone in affiliation with Professor Martijn Cremers. Touchstone Securities, Inc. is independent of Martijn Cremers.

The information provided here is for general information purposes and should not be considered an individual recommendation or personalized investment advice. The investment strategies mentioned here may be not suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. 

Active Share measures the percentage of the Fund’s holdings that differ from those of the benchmark. It is calculated by taking the sum of the absolute difference between all of the holdings and weights in the portfolio and those of the benchmark holdings and weights and dividing the result by two. Index performance is not indicative of fund performance. Investing in an index is not possible. Active Share is not a performance measurement. There are no assurances that any strategy or investment approach will meet its objectives. This information should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. 

Past performance is no guarantee of future results. Active Share is not a performance measurement. A high level of Active Share does not assure outperformance of a fund relative to its benchmark index.

Investing in an index is not possible. Investing involves risk, including the possible loss of principal and fluctuation of value. Please visit touchstoneinvestments.com for performance information current to the most recent month-end.


Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.

Touchstone Funds are distributed by Touchstone Securities, Inc.*
*A registered broker-dealer and member FINRA/SIPC.

Not FDIC Insured | No Bank Guarantee | May Lose Value

About the Authors

martijn cremers

Martijn Cremers, PhD

Professor, University of Notre Dame
Martijn Cremers is the Martin J. Gillen Dean and the Bernard J. Hank Professor of Finance at the University of Notre Dame’s Mendoza College of Business. His co-authored paper published in 2009 introduced Active Share, an innovative tool for determining the extent of active mutual fund management by measuring the percentage of stock holdings in a manager’s portfolio that differs from the benchmark index.
timothy paulin senior vice president touchstone

Timothy D. Paulin, CFA

Senior Vice President
Tim is responsible for product development, enriched portfolio construction and identifying, engaging and monitoring asset managers that sub-advise current and prospective Touchstone mutual funds.

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