Morningstar Magazine - June/July 2018 - 89

Martijn Cremers, professor of finance at the
University of Notre Dame.

bets to some degree, and significant country
and region bets. There isn't a particularly strong
correlation between our active share and
our tracking error. We sometimes will have high
tracking error, and sometimes we'll have low
tracking error, but the active share bounces around
within a relatively narrow range.
Ben Johnson: It's important to emphasize that
active share is a descriptive statistic and to
stop short of inferring that it implies some level
of skill. There will be high active share managers
who perform quite well and indeed may
be skilled, and there will be high active share
managers who perform less well and may be
unskilled or simply unlucky.
Cremers: I very much agree. Active share is
not a measure of skill. However, if investors pay
high fees for a fund, then they should expect
that the fund is quite different than an index fund.
The combination of having a low active share

Ben Inker, head of the asset allocation team
at GMO.

Ben Johnson, director of global passive strategies
research at Morningstar.

and high fees is probably the strongest predictor
I've found for underperformance.

the period you hold that strategy-even if it
outperforms in the long run.

Inker: One of the really nice things about active
share is that it doesn't involve opinions. One
person's definition of active share, at least relative
to a particular benchmark, is going to be the
same as another's.

Johnson: That's something that my colleague Russ
Kinnel has documented for years in his annual
Mind the Gap study. He looks at the differences
between the returns that managers generate-
their time-weighted return-and their Morningstar
investor returns (or dollar-weighted return). If
you split the universe of funds on the basis of their
overall volatility, as a rough proxy for the
aggressiveness of a portfolio, you see that the gap
widens out monotonically as you go from the
least volatile to the most volatile funds, which are
the funds that investors tend to use most poorly.

But I want to pivot a bit to a different point.
Even if a highly aggressive manager also has skill,
that is no guarantee you are going to make
money having hired him. Even skilled managers
will go through some periods where they
are unlucky. Clients who can't take that kind of
volatility should not hire those kinds of managers.
If you can't handle the manager underperforming his benchmark by 10%, don't hire a
manager with close to 10% tracking error. You will
more or less guarantee you're going to fire
him during a time of underperformance, and you
will probably manage to underperform during

Cascade of Conviction
Morningstar has just put out a white paper called
"How Long Can a Good Fund Underperform Its
Benchmark?"4 As our researchers found: a very long

4 Kaplan, P.D. & Kowara M. 2018. Morningstar. March 20.

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Table of Contents for the Digital Edition of Morningstar Magazine - June/July 2018
