Passive Investing Is Driving the Decline of Active Fund Alpha. Here’s What That Means for Investors

An overwhelming body of academic research demonstrates that the past performance of actively managed mutual funds does not provide valuable information as to future performance. For example, Eugene Fama and Kenneth French, authors of the 2010 study “Luck Versus Skill in the Cross-Section of Mutual Fund Returns,” found that fewer active managers (about 2%) were able to outperform their three-factor (beta, size, and value) model benchmark than would be expected by chance.

However, believers in active management were offered hope with the 2009 study by Martijn Cremers and Antti Petajisto, “How Active Is Your Fund Manager: A New Measure That Predicts Performance,” published in The Review of Financial Studies. The authors concluded: “Active share predicts fund performance: Funds with the highest active share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence.”

Active share is a measure of how much a fund’s holdings deviate from its benchmark index, and funds with the highest active share tend to have the best performance. Thus, while there’s no doubt that, in aggregate, active management underperforms and the majority of active funds underperform every year (and the percentage that underperform increases with the time horizon studied), if an investor were able to identify the few future winners by using active share as a measure, active management could be the winning strategy.

You can read the rest of my new Morningstar column here.