Episode 364 – Martijn Cremers: Is the Conventional Wisdom on Active Management Wrong?

Episode Summary

Executive Summary: The episode challenges the simplistic “active management always fails” view. Martin Kramer argues the conventional wisdom from the 1997 Carhart era needs updating: average active underperformance is weaker than commonly believed, performance persistence exists for certain high-active-share/patient managers, and bond markets are fundamentally different from equities. He presents active share as a tool for distinguishing real stock pickers from closet indexers and explains why active fixed income may still add value.

Main Topics: Reassessing the conventional wisdom on active management (Priority: 5/5): Kramer argues the post-Carhart consensus is too negative and based heavily on U.S. large-cap equities, outdated benchmarks, and theoretical rather than tradable comparisons. Active share as a measure of real activeness (Priority: 5/5): He explains active share as a holdings-based measure of how much of a fund differs from its benchmark, useful for identifying closet indexers and genuine stock pickers. Fees, closet indexing, and the active fee concept (Priority: 4/5): The discussion shows why paying active fees for a mostly benchmark-like portfolio can be costly, and why active fee helps contextualize what investors are paying for. Skill, conviction, patience, and opportunity (Priority: 4/5): Kramer’s framework for successful active management requires all three: skill to identify mispricings, conviction to hold differentiated positions, and opportunity in the market and fund structure. Why fixed income is different from equities (Priority: 5/5): Bond indexing is harder because bond benchmarks are huge and illiquid, passive bond funds often look quite active, and bond markets are less efficient and less competitive than U.S. large-cap equities. Evidence on high-active-share and patient managers (Priority: 4/5): High active share alone is not enough, but high active share combined with patient capital and strong prior performance has shown more robust persistence and better outcomes. Investor portfolio construction and risk (Priority: 3/5): Kramer emphasizes that investors should evaluate funds in the context of the whole portfolio, where higher idiosyncratic risk in a fund may improve diversification rather than simply add dispersion.

Key Arguments: The conventional wisdom that active management consistently underperforms is based largely on U.S. large-cap data and on benchmarks that are often not tradable or representative of actual investable passive alternatives. Comparisons of actual active-fund returns versus actual passive-fund returns, including ETFs, weaken the claim that the average active fund underperforms after fees. Active share measures stock-selection intensity, not skill; it is best used to separate closet indexers from genuine active managers. Closet index funds tend to underperform roughly by the fees they charge, making active share useful for due diligence and fee scrutiny. High active share alone is not a reliable predictor of outperformance, but high active share combined with patient capital and past success has shown stronger persistence. Bill Sharpe’s arithmetic of active management is too static because the market portfolio and passive implementation change over time; passive investing also involves trading and market impact. The shift to index funds may improve opportunities for the remaining active managers by making the industry less crowded, though U.S. large-cap equities remain highly efficient. Bond markets are structurally different: passive bond funds often have high active share because full replication is costly, and active bond funds have historically done relatively well. In fixed income, the usual equity arguments for indexing based on skewness and superstar winners do not hold nearly as strongly. Investors should choose between indexing and active management based on goals: low cost and simplicity versus the possibility of downside protection and differentiated returns, recognizing the research burden involved in selecting active funds.

Data Points: Carhart benchmark era: 1997 - Kramer says the traditional negative view of active management is largely summarized by Mark Carhart’s 1997 paper. Active share paper published: 2009 - Kramer and co-author Antti Petajisto introduced active share in their 2009 paper. Recent literature review horizon: ~25 years - Their 2025 paper reviews roughly the last 25 years of academic research after Carhart. Typical rank correlation between active share and tracking error: 20–25% - He says active share and tracking error are related but only modestly correlated. Vanguard/Magellan active share: 34% - The Fidelity Magellan Fund had 34% active share in 2003, meaning 66% overlapped with the S&P 500. Low-active-share closet indexing cutoff: below 60% - Kramer uses 60% as a practical example cutoff for closet indexing, especially in large-cap funds. Estimated share of U.S. equity assets in closet index funds: about one-third - In 2003, around a third of U.S. equity fund assets may have been in very low active share funds. Median active share of passive equity funds: about 2% - Used to contrast truly passive equity funds with passive bond funds. Median bond-level active share of passive bond funds: 55% - Shows that fixed-income index funds often deviate substantially from their benchmarks. Average active bond fund outperformance: 28 bps/year - In their bond study, active bond funds outperformed passive counterparts by about 28 basis points annually, with only modest statistical confidence. Average fund holding period: 1 to 1.5 years - Kramer says most active managers are not very patient and turn over positions relatively quickly. High-active-share fund evaluation window: Five-year periods - Active share tends to be quite persistent across five-year windows. Current large-cap benchmark concentration: A relatively small number of stocks drive performance - He notes the S&P 500 has become concentrated, complicating active management in U.S. large caps. Bloomberg U.S. Aggregate constituents: More than 12,000 securities - Illustrates why fixed-income benchmark replication is hard.

Pivotal Quotes: "the average active Managed fund underperformance becomes much weaker or is not there on average statistically." — Martin Kramer: He is explaining how using actual passive fund returns instead of theoretical factor benchmarks changes the evidence on active management. "The best you can ever hope to get from a bond is exactly what it promises to pay you." — Martin Kramer: He is contrasting the limited upside of bonds with the skewed upside distribution of equities. "The three pillars framework... skill, conviction, and opportunity." — Martin Kramer: He summarizes what successful long-term active management requires in his research framework.

Implications: Investors should be more nuanced about active management: avoid closet indexers, recognize that some high-active-share strategies may warrant scrutiny, and treat fixed income differently from equities. The key question is not active vs passive in the abstract, but where active skill, patience, and market structure justify the fee.