Does the Evidence Behind Active Share Hold Up?

Yesterday, we discussed a paper by Antti Petajisto showing a new method for identifying outperforming active managers, called Active Share. Basically, Active Share is the portion of a mutual fund that deviates from its benchmark. Of course, such a discovery needs a closer look.

At first glance, it seems that Petajisto has truly found the Holy Grail of mutual fund investing. After reviewing the paper, I offer the following observations and cautions:

Longer Time Frame Needed While Petajisto noted that he had data available back to 1980, he chose to exclude the 1980s because there weren't many closet indexers during that time. While excluding the period makes sense if his main objective was to study the cross-sectional relation between Active Share and return, if his thesis holds true, the performance of the stock pickers should still be strong during this period. It would have been a good additional test to include the results of the stock pickers for the 1980s.

Big Winners Skewing the Results? The study reports time series averages of equally-weighted average returns. But the average could be positive due to a skewed distribution: A few highly concentrated funds may have enormous returns, increasing the average for the stock pickers. It would have been helpful to report the median. This would give us an indication of whether the probability of picking a winning fund is above 50 percent. As it is, we don't have any idea of the probability of picking a winning fund.

When funds are sorted by both fund type and fund size, only the very smallest quintile of stock-picking mutual funds showed a statistically reliable abnormal return (t-stat above 2). This tells us that the only funds that generated reliable out-performance were the very smallest stock pickers. This reinforces the idea that skewness could be driving the results.

Incubator Bias Affecting the Results? The smallest funds typically are young funds. Thus, the well-documented incubator bias could be driving the results. (Incubation bias results when a mutual fund family wishing to launch a new fund nurtures several at a time. Funds that beat their benchmarks go public while poorly performing ones never see the light of day.) If this bias exists, the reported returns for small funds don't mean much. The persistent performance of the best stock pickers could also be due to incubation bias.

Summarizing, the results of this paper say that the way to pick a winning fund is to find a stock picker that has a small fund and good performance in the prior year. But that's precisely the group of funds that would be most impacted by incubation bias. In addition, it was only the very smallest of funds that showed any statistical significance. Since we know that fund flows follow performance, a successful small fund isn't likely to stay small for very long. And since there's no statistical significance beyond the smallest quintile, there doesn't seem to be much evidence for a belief in a Holy Grail being found.

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