However, Antti Petajisto claims he has found the Holy Grail, called Active Share. Active Share is the percentage of holdings that differ from the funds benchmark.
- The S&P 500 Index, which is the passive component
- The deviations from the index, which is the active component
Keep in mind that an active manager can add value only by deviating from a benchmark -- either through stock selection (betting on individual stocks) or factor timing (tactical asset allocation involving betting on broad portfolio factors such as overweighting value stocks or shifting to cash equivalents). In his study, Petajisto used the time period 1990-2009 and controlled for the four factors of beta, size, value and momentum. He found that:
- The average fund underperformed its benchmark by -0.41 percent.
- Moderately active funds underperformed by -0.52 percent.
- Factor bets generated underperformance of -1.28 percent.
- Closet indexers (those with low active share) underperformed their indexes by -0.91 percent, slightly less than their fees.
- Concentrated funds essentially just matched their benchmarks net of fees.
- The only group that added value to investors was the active stock pickers: They beat their benchmarks by 1.26 percent, or 1.39 percent after controlling for the four-factor model.
Petajisto concluded that the "cross-sectional dispersion in stock returns positively predicts average benchmark-adjusted performance by stock pickers." He added: "Active share has greatest predictive power for returns among small-cap funds, but its predictive power within large-cap funds is also both economically and statistically significant."
Finally, Petajisto concluded that "There are some inefficiencies in the market that can be exploited by active stock selection. However, fund managers are not able to add value by betting on broader factor portfolios, indicating that they are more efficiently priced than individual stocks."
These findings are certainly surprising, and no doubt many active managers will be ready to say "I told you so." However, given the mountain of evidence against active management, papers like these always warrant a closer look. Tomorrow, we'll do just that.
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