Active Mutual Fund Performance

Frederik Kofoed Hansen

Student thesis: Master thesis


This paper investigates the ability of Active Share in combination with tracking error to identify superior active equity mutual funds in large European markets and small markets across the world. The limited previous research has focused on the U.S. market and shown that stock-picking funds with high Active Share significantly outperform their benchmark while funds with low Active Share and low tracking error, identified as closet indexers, significantly underperform. This study looks at two samples of funds with European large cap benchmarks or benchmarks with less than 100 constituents from 2008 to 2015. Active Share levels are found to be low with 20% to 40% of funds in large European markets and 60% of funds in small markets having an Active Share below 60%. This is possibly due to a lack of competition and passive investment alternatives. Alternatively, limited market capitalization, investable securities, and liquidity in small markets make it hard for funds to deviate substantially from benchmark holdings and thus achieve a high Active Share. This paper finds evidence that more active funds in terms of Active Share outperform less active in large European markets. This is not the case for funds in small markets and when looking at activeness measured by tracking error. Closet indexers show statistically significant underperformance net of fund fees compared to their benchmark in large European markets, which indicates that investors should avoid investing in these funds. There is less evidence of this in small markets, which suggests that Active Share and tracking error have limited ability to identify true closet indexers in small markets. Diversified stock pickers, identified by high Active Share and relatively low tracking error, show statistically significant positive gross benchmark-adjusted returns but not net of fund fees. However, stock pickers with the best prior-month performance show annualized benchmark-adjusted return of 2.9% before fees and around 1% after. Moreover, there is evidence that stock pickers benefit from being small in small markets, likely due to issues of liquidity and limited investment opportunities that large funds face. In contrast, factor bets, characterized by low Active Share and high tracking error, benefit from being large in large markets possibly due to economies of scale. Choosing the most expensive fund managers is not recommended for investors as these are not able to provide high enough returns to outperform the cheaper managers on average net of fees. In large European markets investors can thus use Active Share and tracking error to steer away from closet indexers and focus on selecting stock-picking fund managers with a good track record. Active Share and tracking error have less applicability for investors in small markets, but there is still evidence that some active managers are able to outperform their benchmark. Active Share is therefore a useful measure but it needs to be applied with thought and in combination with other analysis tools in order to select the best mutual fund managers.

EducationsMSc in Finance and Investments, (Graduate Programme) Final Thesis
Publication date2016
Number of pages145