Active Share Supported by Tracking Error as Investment Tool for Retail Investors: An Empirical Study on Funds With Different Benchmark Structures

Sigurd Djurhuus Carlsson

Student thesis: Master thesis


This report examines whether a retail investor with the use of two measuring tools of active management, active share and tracking error, can increase his expected return by investing into funds with specific investment styles. The methodology is from Cremers & Petajisto (2009), which categorize an active management into either a: Stock Picker, Concentrated Stock Picker, Closet Indexer or Factor Bettor based on Active Share (proxy for stock selection) of their portfolio holding and Tracking Error (proxy for factor bets) of their ex-post returns. The study includes a sample of 992 funds with 29 different benchmarks in the period 28/02-2003 – 31/05- 2015, without making any further decomposing on the sample there is evidence of outperformance by a certain type of management. In the full sample, Concentrated funds generated statistical significant abnormal returns even after adjusted for fees. However, causality was detected between the fund’s benchmark structure and the classification of the fund. Thus a numerical model was set up to clarify how active share was affected by an increase in constituents of the benchmark, which showed evidence of a positive relationship. Thereafter all the funds benchmarks were sorted after size and average asset correlation into four equal portfolios, namely: Large Market High Correlation, Large Market Low Correlation, Small Market High Correlation and Small Market Low Correlation, which represent four different investment universes for the funds. The performance evaluation of the four market conditions shows that Cremers & Petajisto (2009) conclusion on outperformance by high active share funds is sensitive to the funds benchmark structure in terms of size. The performance evaluation for the smaller markets differed substantially from Cremers & Petajisto’s (2009) findings on active share. In smaller investment universes low active share funds generated significant positive abnormal gross returns in the same extent as high active share funds. Findings on funds in larger investment universes, on the other hand, points towards the use of Active Share and Tracking Error as investment tool for retail investors. Concentrated funds generated statistical positive returns, while Closet Indexers and Factor Bettors generated negative returns after adjusted for fees on larger markets. Thus this thesis suggests that retail investors interpret a fund’s active share level conditional of its investment universe, since empirical findings of this paper depends on the fund’s benchmark structure.

EducationsMSc in Finance and Investments, (Graduate Programme) Final Thesis
Publication date2017
Number of pages134