When assessing mutual funds, one thing we look at closely is “active share.” Although the average investor isn’t familiar with this term, it gets at a very important issue: To what extent does a mutual fund’s portfolio mimic the “benchmark,” or the specific index that fund is evaluated against? Say a fund owns 480 of the 500 stocks in the S&P 500 in roughly the same proportion. Its “active share,” or the percentage of its portfolio that deviates from the benchmark, would then be really low. “So what?” you might ask.

There’s actually nothing wrong with having low active share, as long as that’s part of the fund’s stated goal. Index funds and ETFs that mimic stock indexes, for example, aim to have zero active share. And because they basically copy the index, the management fees they charge are correspondingly low.

Off the beaten path

To have a chance of outperforming his/her benchmark, however, a fund manager has to deviate from that benchmark, either by investing in fewer securities (concentration) and/or in different securities. Straying from the benchmark increases a fund’s risk, as well as the potential return. So it’s a double-edged sword. Only if a fund has high active share and the manager’s investment approach is effective is the fund likely to outperform its benchmark over time.

Paying attention to active share also helps in avoiding excess fees. If, for example, we see that a fund manager tends to be a “closet indexer” (his portfolio has low active share) yet the fund charges the higher fees that active management warrants, red flags go up. In this case, relatively high fees and index-like returns mean this fund is likely to underperform after fees.

The level of active share matters

There have been several interesting studies on active share. While exact cutoffs differ, it’s widely agreed that given an active share of less than 60% to 70% — in other words, at least 60% to 70% of the portfolio mirrors the benchmark – the fund should be considered a closet indexer, or at least not active enough to justify charging active-management fees, due to the low probability of meaningfully outperforming its benchmark.

According to a 2013 analysis of global equity funds by Lazard Asset Management, the threshold of 60% to 70% active share makes sense; that’s about when returns begin to outpace the benchmark. Take a look at the chart below. As you can see, the global equity funds with the highest active share also tended to have the highest excess return relative to their benchmark.

Global equity fund performance 2007-2011.
Source: Lazard Asset Management, “Taking a Closer Look at Active Share” by Khusainova and Mier, 2013.

In a 2009 study of U.S. mutual funds, “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” by Martijn Cremers and Antti Petajisto, a threshold of at least 60% active share was deemed indicative of active management.

Some caveats

Although active share is a powerful tool for ferreting out funds that are closet indexers, it should not be used as a standalone measure to gauge the extent of active portfolio management. That’s because active share data can be distorted by the benchmark used, the investment style of the manager, and by temporary shifts in portfolio holdings. That said, active share plays a key role in how we assess the universe of actively managed funds. Our ultimate goal is to make the best possible use of both index funds and actively managed funds to create cost-effective portfolios that control for risk while maximizing return for that level of risk.