July 3, 2025

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

July 3, 2025

Martijn Cremers serves as the Martin J. Gillen Dean and the Bernard J. Hank Professor of Finance at the University of Notre Dame’s Mendoza College of Business. Cremers served as interim dean starting in 2018 before accepting the position in 2019; he was recently reappointed to serve a second term that will run through 2029. Before joining Notre Dame in 2012, Cremers was a faculty member at the Yale School of Management from 2002 to 2012.

His research and teaching areas are investment management and corporate governance. Cremers serves as an academic advisor to Touchstone Investments (Cincinnati, OH) and as an independent director at Ariel Investments (Chicago, IL). A native of the Netherlands, Cremers earned his master’s degree from the Free University Amsterdam and his Ph.D. in finance from NYU’s Stern School of Business.

In this episode, we’re joined by Martijn Cremers, Dean of the Mendoza College of Business at the University of Notre Dame and co-author of the groundbreaking 2009 paper that introduced the concept of Active Share. Martijn brings fresh nuance to the long-standing debate over active versus passive management, challenging decades of conventional wisdom built on the foundational 1997 Carhart paper. With his comprehensive research, Martijn argues that dismissing active management may be overly simplistic—especially in less efficient markets like bonds, small-cap equities, or emerging markets. Together, we explore how empirical support for passive superiority has softened in recent decades, the overlooked structural flaws in performance benchmarks, and how closet indexing quietly undermines the active management space. Martijn outlines the three pillars of active success—skill, conviction, and opportunity—and makes a compelling case for patient, high active share strategies that persist over time.

Key Points From This Episode:

(0:01:24) Introduction to Martijn Cremers and his influential work on Active Share

(0:04:15) Breaking down the “conventional wisdom” on active management post-Carhart

(0:07:19) Why passive benchmarks like Fama-French factors may create misleading comparisons

(0:09:38) Reviewing persistence of outperformance in high active share funds

(0:12:40) Evaluating Sharpe’s arithmetic and how market evolution challenges zero-sum assumptions

(0:15:58) The long-term decline of active funds and the influence of concentrated indexes

(0:18:30) The paradox of skill, ETFs with high active share, and the survival of active managers

(0:21:18) Revisiting active management in underexplored asset classes: bonds, small caps, emerging markets

(0:23:20) The definition and calculation of Active Share

(0:25:01) Active Share vs. Tracking Error: complementary tools, not substitutes

(0:27:22) What level of active share signals closet indexing? Why 60–70% is the key threshold

(0:30:49) Performance persistence and why combining high Active Share with patience matters

(0:34:05) The concept of the “active fee” and how much you’re really paying for stock selection

(0:36:51) Why fund size and team changes can erode active share

(0:38:17) Three pillars of successful active management: skill, conviction, and opportunity

(0:40:13) The challenge of being a patient manager in an impatient world

(0:42:25) How Active Share was received by academics and practitioners

(0:44:18) Responding to critics: the 2016 FAJ paper “Deactivating Active Share”

(0:46:56) Why dispersion in high active share funds can enhance portfolio diversification

(0:49:21) Who should pursue high active share strategies—and who shouldn’t

(0:51:40) Active share in fixed income: Why passive bond funds are often far from passive

(0:53:51) Key structural differences between equity and bond indexing

(0:55:25) Why bond index funds have high active share and hidden tracking error

(0:57:36) Why positive skewness (a key argument for equity indexing) doesn’t apply to bonds

(0:59:22) Performance of active bond funds: modest but consistent outperformance

(1:00:02) Why active bond funds remain popular: liquidity, trading frictions, and benchmark limitations

Read The Transcript:

Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We're hosted by me, Benjamin Felix, Chief Investment Officer and Cameron Passmore, CEO at PWL Capital.

Cameron Passmore: Welcome to episode 364. Today's episode is a phenomenal conversation. Kudos to you, Ben, for getting this guest today.

But you know, the eternal question of active versus passive and the – I think a lot of listeners are familiar with the term active share, but you went right to the source to dig into both of those, which I thought was fascinating. It's a nuanced discussion and if you keep open mind about this whole thing, which I think we tried to do, so you got to give again the back story. I love the back stories and how these things all come together to get to Martijn Cremers on.

Ben Felix: It's just one of those things where active shares has become such a fundamental concept in finance. It's a bit of a – I don't know if I'd quite call it divisive, but it's an idea that stirs up a lot of debate because it is a tool that, as Martijn talks about in this episode, can be potentially used to find active funds that are more likely to outperform, which is something that's antithetical to the whole concept of index investing and believing that nobody can beat the market consistently, and that you cannot identify active managers. Now, to be clear, we're not changing our minds here and saying that we think we can pick active funds now, but Martijn does make good nuanced arguments about when that could potentially make more sense if an investor wants the type of distribution of outcomes that an active fund can provide. So again, we're not switching up and saying, okay, we're going to start picking active funds now, but I do think it's important to hear different perspectives like Martijn's where he can get some color to the idea that, hey, maybe the conventional wisdom on active management as it is today in 2025 and the conventional wisdom being what I just said, that you basically can't beat the market, nobody can beat the market consistently. Martijn's able to provide a more nuanced perspective on that backed up by years of research that he has done.

Cameron Passmore: And not just in equities. We had a whole conversation around fixed income returns as well.

Ben Felix: Yeah. I want to do a video on that. Does index investing still make sense in fixed income?

Because I think that is a really, really interesting topic. We use dimensional funds for fixed income, which are very much not index funds, even less so, I think, than their equity funds are not index funds. Their bonds are even, to use Martijn's language, have an even higher active share.

Anyway, that's a whole interesting topic and we spent the later part of the episode talking about that. Martijn is very well known for active share. He had a 2009 paper that invented that concept, which is now all over the place.

It's a very common way in the finance literature to measure how active a fund is, which is important for all kinds of reasons and all kinds of ways of looking at asset management. I think Ralph Koijen, for one of his papers, looking at how the investment industry has changed over time, he uses active share to measure how assets have shifted from active to passive over time. Anyway, it's not just for finding funds that might outperform.

There's all kinds of interesting applications to the concept of active share. Martijn is the Martin J. Gillen Dean and the Bernard J. Hank Professor of Finance at the University of Notre Dame's Mendoza College of Business. Prior to that, he was a faculty member at the Yale School of Management from 2002 to 2012. He's got his PhD in finance from New York University's Stern School of Business.

As we've mentioned a couple of times now, very well known for his work on active share, but he's done a ton of interesting research on just the concept of active management in general, how to evaluate it, how to potentially increase the odds of finding a manager that might outperform. And we talked about all that throughout this conversation. We did an episode recently talking about not making your beliefs part of your identity.

And this is not the first time we've done this. We had Andrew Chen on that very much challenged many of our beliefs, but I think it's really important to have perspectives like this that are different from what we usually talk about. I think we do fall into what Martijn talks about of conforming to the conventional wisdom about active management, but that conventional wisdom is based on research that ended in 1997 with Mark Carhart's paper that was the slam dunk.

This is done. Active management is terrible.

Cameron Passmore: Isn't that amazing how long ago that was?

Ben Felix: Right.

Cameron Passmore: Incredible.

Ben Felix: And as Martijn highlights, there's been a lot of research since then on active management that's disconfirming to the conventional wisdom.

And so we got a lot of that color from him today. He did also want to disclose, and he mentions this briefly during the recording, he's an independent director at Ariel Investments and he's an independent consultant with Touchstone Investments and those are both active managers.

Cameron Passmore: Great. Super setup. I think we're safe to go to our conversation with Professor Martijn Cremers.

Ben Felix: Let's go. Martijn Cremers, welcome to the Rational Reminder Podcast.

Martijn Cremers: Thank you for having me.

Ben Felix: We're super excited to be talking to you. Your research is fascinating and a lot of our listeners will know about it, so I think it's a real treat to be talking to you.

Martijn Cremers: Thank you.

Ben Felix: All right. To kick off, today in 2025, after decades of academic research, starting with Jensen's paper in 1968, what is the conventional wisdom on active management?

Martijn Cremers: Yeah, we published a paper on that in Financial Analyst Journal a couple of years ago where we defined the conventional wisdom of active management as the summary of a seminal paper published in 1997 by Mark Carhart. And then we summarized the conventional wisdom and then look at the last 25 years or so of academic research to see how much of that conventional wisdom has actually borne out by the new academic research. So we read hundreds of academic articles and summarized them so that you don't have to read all of them.

So the conventional wisdom, as I understand it, consists of three parts. First, that the average fund, actively managed fund, underperforms after fees. Second, that the funds that may outperform, that their outperformance doesn't persist.

So there's no positive performance persistence. For example, Carhart, in his 1997 paper, he concluded that any performance persistence could be explained by stock price momentum. And after investment costs were incorporated, he found that there's no predictability left.

Then third, that yes, some fund managers may be skilled according to the conventional wisdom, but investors cannot benefit from such skill due, again, to higher costs.

Ben Felix: Those are all arguments that we're definitely familiar with and we've probably said many times ourselves on this podcast. So how well supported is that conventional wisdom by the academic literature?

Martijn Cremers: So we looked at hundreds of papers published after Carhart's paper. First, on the notion that the average fund underperforms after fees. What we found is that many recent studies, including some of my own, found that this evidence is not that strong empirically.

The underperformance of the typical actively managed fund. In the literature, this result was based on comparing the returns of active funds to the returns of passive funds, of course. But most of this literature compared the actual returns of actively managed funds to the theoretical returns of passive funds, or of using some type of factors, benchmarks that were not actually investable, that were not tradable.

What the literature hasn't really done until recently is do something that I think is very basic. That is to compare the actual returns of actively managed funds to the actual returns of passively managed funds, including the returns on ETFs. And once you do that, then the evidence that the average actively managed fund underperforms becomes much weaker or is not there on average statistically.

One simple example is that many papers in the literature have used the Fama–French factors. In a separate paper I wrote with some co-authors, we find that the Fama–French factors are actually quite, we think, biased representations of the actual markets in equities that mutual funds invest in. So the Fama–French factors heavily overweight small cap stocks and small value stocks, which historically have outperformed, but they are not a good representation of the equity market that mutual fund managers actually invest in.

So it creates an unrealistic benchmark that's also very hard to beat and that leads to all kinds of issues related to performance evaluation. And so the simple solution is to compare actual returns of actively managed funds to the actual returns of passively managed funds that investors would be interested in tracking. If you do that, then again, the results of the conventional wisdom don't really hold that strongly.

Then the lack of performance persistence, there's a whole bunch of papers in the literature that have found evidence for positive performance persistence of actively managed funds that survive momentum auto-factor adjustments. There's the Bollen and Busse paper from 2005, the Kosowski, Timmermann, and Wermers, and White paper from 2006. And in our own 2009 paper that introduced active share that I co-wrote with Antti Petajisto, we found very strong positive performance persistence for equity funds with the highest active shares.

Ben Felix: That's really interesting. That first part reminded me of the Berk and van Binsbergen paper. I think they talk about that with the Fama-French factors not being a great benchmark.

We had them on our podcast a while ago and I remember them talking about that.

Martijn Cremers: Oh, exactly. We cite them extensively in our challenging bigger financial wisdom paper. Yeah, they wrote some seminal papers exactly on this topic.

Cameron Passmore: Interesting. And in your opinion, Martijn, does the conventional wisdom judge active management fairly?

Martijn Cremers: In 1997, yes. But I think in the last 25 years, we have a lot more evidence that I think the conventional wisdom needs to be updated. That's what we try to do in our paper.

At the same time, outperforming the benchmarks is incredibly difficult. And financial markets, especially US equity markets, are very, very liquid, have increasingly become more efficient, more competitive, more liquid. And so there's certainly no evidence that the average equity funds in the United States outperforms after fees or that it's easy to find funds that outperform after fees.

So in that sense, if that's the conventional wisdom, then that holds. But the other side is that it's all doom and gloom for active management. I think that's too negative.

Ben Felix: That's the big question from Berke and van Binsbergen versus Fama and French in their 2010 paper is, are average net alphas zero or are they negative? That's my question, right?

Martijn Cremers: Exactly. And my conclusion is the evidence that they're really negative is statistically not very strong. And it's easy to overturn that with different methodological adjustments or looking at different data.

I think for large cap stocks, there is some evidence that once you look at a broader number of investment styles, if you go to small caps, mid caps, you go to international equities, emerging markets, but also to bonds. I think the evidence for active management is much stronger.

Ben Felix: Yeah. We got some questions about that later. So if that's true, how does that square with Bill Sharpe's arithmetic of active management, which it's at least perceived as a tautology that active must underperform on average?

Martijn Cremers: Yeah. He wrote a very influential paper on that where he argued, right, that it's a zero sum game before fees that creates a negative sum game after fees. A couple of years ago, another brilliant finance scholar, he wrote a paper on this where he made, I think, a very convincing point, at least convincing to me, is that he argued that Sharpe's arithmetic of active management is implicitly assuming that we know what the market portfolio is, we know what the benchmark is, and that is basically constant.

He points out, and I think rightly, that is not at all the case. The market portfolio changes constantly. Passive funds have to trade a lot too.

There's a lot of things that happen in the markets. It's not a zero sum game. At the same time, I think that Sharpe's other point is that fees matter.

Efficiency and competition are very, very important. I think those points are very well taken and remain very important.

Ben Felix: It's footnote four, I believe, from Bill Sharpe's paper where he acknowledges that, hey, this only holds true if nothing changes, if there's no trading. Yeah, we talked about that on a podcast recently.

Martijn Cremers: If you think about the market portfolio 10 years ago versus now, and if you would have just held those stocks that were in the market portfolio then versus what would have happened in the last 10 years, you would have a completely different portfolio and set of returns.

Cameron Passmore: Yeah. How has the shift of investment dollars towards index funds affected the active management industry?

Martijn Cremers: For U.S. equities, it's been a very tough decade, maybe even tough two decades. Active managers, especially in U.S. large caps, they have had to deal with massive aggregate outflows. Also, with a large cap benchmark, think of S&P 500, it has become fairly concentrated with a relatively small number of stocks that have been driving much of the stock market performance.

It's a shift of investment dollars away plus a market dominated by a small number of names that I think have been particularly challenging for the active management industry, again, especially for U.S. large caps.

Ben Felix: Are those flows affecting asset prices, which is then making it harder for active managers to outperform?

Martijn Cremers: That's not an area that I study close to myself. My simple intuition is probably got to be some demand and flow effects. Another aspect here is that a lot of the flows into ETFs are not necessarily in ETFs that have very low active share, are just based on market weights.

A lot of the new products that are gaining a lot of assets in the ETF space are more complex products. And many of those may not actually be that passively managed. I think of passively managed as products that really closely follow market cap weights.

Anything beyond that, in my view, already gets into active. There's so many different indices now that different ETFs follow. I do think that opportunities for active managers will improve as fewer active managers remain.

But in large cap equities, markets are very competitive and efficient. There are significant opportunities elsewhere, I think. Mid and small cap value international emerging markets, but also other asset classes, including private assets and, of course, bonds, which we may talk about later.

But bond markets are a lot less liquid and efficient than equity markets.

Ben Felix: If the current trend toward index funds continues, are you saying that makes it a better environment for active managers, for the remaining active managers or worse?

Martijn Cremers: If for the ones that survive, it should be a better market. Because the competitor will remain investment opportunities, especially, I think, for more patient active managers. If the fewer of them left, it's going to be less competitive.

I expect that those who are able to survive this massive outflow can improve their performance in the longer term.

Cameron Passmore: Fascinating.

Ben Felix: What about the paradox of skill idea? If there's the only two remaining active managers are both the best ones by far, the outcome of their competition becomes more driven by luck than their skill. Do you have thoughts on that?

Martijn Cremers: Yeah. I don't think that skill is one-dimensional or even small dimensional. I think skill is many-dimensional.

There's so many very, very complex problems that I think, as a society, we're trying to figure out, let alone how that will affect asset prices going forward. Take something like AI or many macro things currently ongoing. So different managers may have different skills that I think can incorporate information and understand issues that, in the end, markets will figure out.

But yeah, I don't think that markets are automatically super efficient. I think it does take real skilled analysts to analyze information and incorporate that in asset prices.

Cameron Passmore: I'm curious, how do you think all of this affects the interpretation of past research and active management?

Martijn Cremers: Well, you know, the standard caveat, right? The past doesn't necessarily predict the future. The main way I think about it is that the past literature, and that's also how we conclude our paper on challenging the conventional wisdom, is that the past literature has very largely focused on U.S. equities, especially large caps. And I think the future research and active management may be more fruitful, especially because, again, U.S. equity large cap space has become so efficient and competitive, is outside that. So I think, again, small caps, mid-caps, private assets, bonds, other asset classes, international and margin markets. I would think that many of the conclusions from the literature on U.S. equities will apply to those others.

Ben Felix: All right, we're going to move on to your research on active share, which I think is what you're probably best known for. At least that's how we knew who you were initially before reading all the rest of your stuff. Can you talk about the main ways that an active equity manager can be different from the index in an effort to try and beat it?

Martijn Cremers: Yeah, there are many ways that active managers can try to beat the benchmark index. You can distinguish, for example, managers who focus on factor and market timing, including sector exposure, sector rotators, versus a very different type of manager that focus on individual stock picking and security selection in particular. I think that's the dimension that active share is really only focused on, is how much security selection a manager is doing.

Regardless of the particular style, all managers need other skills, like trading skills, liquidity skills, tax management skills. Again, active share is really focused only on what I think of security selection skills.

Ben Felix: How does active share measure how active a manager is?

Martijn Cremers: Active share is a very, very simple measure, very basic. It compares the holdings of the funds to the holdings of the fund's benchmark. It's a purely relative measure, fund versus its benchmark.

Any security that is both in the fund and in the benchmark in a long position will create some overlapping weights, which is the minimum weight across the two, weight in the fund versus weight in the benchmark. For example, if a stock would be 4% in the benchmark and 6% in the fund, then the minimum or overlapping weight across the two is 4%. Then the funds, the actively managed funds, has a 2% overweight in the stock.

Then to calculate active share, take all the securities that are in both the fund and the benchmark, calculate the overlapping weight of each, then sum up all the overlapping weights across all the stocks that are in both, and detract that from 100%, and you have active share. In other words, active share is the percentage of weights or holdings in the fund that is not one for one overlapping with the weights in the holdings in the benchmark. My view of active share is then it's a measure of how much security selection of individual stock picking a manager engages in.

Cameron Passmore: What made active share a valuable contribution to the academic finance literature?

Martijn Cremers: Yeah, we published a paper in 2009. We made our first one available in 2006. It was actually the first paper I ever wrote on mutual funds.

So if you read the paper, please forgive me. It was my first ever paper. My coauthor had done a couple of papers on mutual funds already.

It was my first ever mutual fund paper. What made I think valuable is active share is a very, very simple basic measure, but it allows you to differentiate funds by looking at how much stock picking a fund manager is actually doing. So if you are looking for an active manager, it's useful to know what part of the fund is actually different from the benchmark.

When I look for a fund that does a lot of stock picking, does the fund then indeed have a high active share? More generally even, if you're paying high fees for a fund, you would want that fund to be different than the benchmark and does not have a low active share. And that's also how I think our paper initially got a lot of attention, because one of the things we documented in our paper, and our data ended in 2003, so this is a long time ago.

But at that time, we found that a large percentage of the market in US equities, especially large cap US equities, had very high fees and had very low active shares. The largest equity fund at the time, the Fidelity Magellan Fund, they had an active share of 34%. So 66% of the Fidelity Magellan Fund at that time, 2003, was one for one overlapping with the S&P 500.

Ben Felix: Yeah, that's wild. Did you guys come up with the term closet index fund?

Martijn Cremers: We did not.

Ben Felix: Okay.

Martijn Cremers: No, we came up with the term active share.

Ben Felix: Okay. Interesting. Because closet index funds became, and I think probably still are, a pretty big deal.

How is active share different from tracking error?

Martijn Cremers: Yeah, so tracking error is this additional measure of active management. So both measures look at how the fund is different from the benchmark. So active share looks at portfolio weights, the holdings, and is based on a snapshot in time, and completely ignores returns.

And so therefore, active share also completely ignores any cross-correlation structure between these securities in the funds and in the benchmark and everything else. So tracking error considers the difference in returns or is the volatility of the difference in the return of the funds minus the return of the benchmark. So tracking error is based on historical returns and is also backward-looking, not a snapshot in time.

So the two measures, I think, can be very fruitfully used together. They're not competing measures. They are possibly correlated, but not that much.

When I calculated in my samples, the typical rank correlation is 20%, 25% only. So it's not that high. So yes, if you know the active share or the tracking error, you have a sense of what the other could be, but there's still a lot of variation.

It's very fruitful, I think, to combine them. For example, if you think about active share and you think about the active overweights and underweights or the active bets that a fund is taking, you can ask, well, how well diversified are those active bets? And if these active bets are very well diversified and the funds can have a high active share, but not that high a tracking error.

And if the active bets are not well diversified, for example, if a fund focuses on a certain style or industry or a particular factor, then the funds can have a high tracking error, even if it does not have a high active share. And that's actually the case, I think, for many of the factor investing funds out there that often have not that high an active share, but significant tracking error.

Cameron Passmore: What is the active share cutoff for a fund to be considered a closet index fund?

Martijn Cremers: That's, I think, somewhat subjective. The active share helps you to figure out what part of the fund is actively managed, what part of the fund is very different. But the right cutoff is to some extent subjective, but I'm glad to share how I think about that.

One important consideration is to recognize that it really does matter what type of securities you invest in. For example, for large cap funds, the benchmark is more dominated by a few very large stocks. And so I think you would naturally expect a lower active share than for small cap funds.

Because if you want to, to some extent, give your investors what they're looking for, exposure to that space, you have to have some overlap with these large names. If you take a couple of steps back, and you're considering a fund that is focused on stock selection, a very basic question to ask is what percentage of the assets in the fund's benchmark universe can outperform? If you assume, which is not the case, but if you assume that stock returns in the cross section are strictly symmetrically distributed, then you would expect that about 50% of the assets weights would outperform 50% on the performance.

However, stock returns are not at all symmetrically distributed. They're quite positively skewed, where a small number of names have very, very high returns, and a typical stock actually underperforms. So that means that considerably less than 50% of the assets in any benchmark will outperform.

And it's skewed enough as for large caps, maybe only 40%, or even 30% of the assets would be expected to outperform and the rest will underperform. If the task of the fund manager is to find stocks that outperform, you want the fund manager to think that I'm going to need to look in that 30 or best 40% of assets. And then going back to active share, that would translate into an overlap that cannot be larger than 30 or 40%.

You want to end up with an active share of at least 60%, or maybe even at least 70% using that logic of the active manager should be looking for stocks that are going to outperform. And the manager cannot think rationally, let's say more than 40% of the assets in the benchmark will do so.

Ben Felix: Do you have a sense of what proportion of active funds today are closet index funds?

Martijn Cremers: You need to define a cutoff. So let's say 60%. That proportion has changed a lot over time.

It also differs very much by fund style and asset class. Very few small cap funds have a low active share. Among the closet index funds with active shares below 60%, almost all of them are going to be large cap funds.

That's an aspect of the markets that I don't think I appreciated when we wrote our initial paper. That was not our focus at all. So closet indexing is most prevalent among large cap funds.

It was quite uncommon until about the mid 1990s. For almost no, even large cap funds with active shares below 60%, even in the early 1990s. And then closet indexing became quite common, especially leading up to the early 2000s.

When we wrote our active share paper in 2009, our data ended in 2003. At that point, maybe a third of assets in US equity funds were in really low active share funds that you could classify as closet index funds. Since then, something very interesting has happened.

On the one hand, the assets in really low actively managed US equity funds has dropped. So closet indexing, let's say active share below 60%, has become less common. At the same time, the percentage of assets in funds with really high active shares, let's say 90% or above, has not increased.

It has seen a slow continued decline. So in other words, the aggregate or average active share of equity funds in the United States has continued to trend downwards, roughly speaking, for the last three decades. And more funds now are somewhere between 60% and 70% active share.

Cameron Passmore: How do you describe the concept of a fund's active fee?

Martijn Cremers: The starting point for thinking about active fee is to relate the fees that you're paying for, how much active management are you receiving? Exposure to the markets, again, for US equities, is, of course, very inexpensive.

So beta needs to be cheap. Investing in broad-based market indices should be low cost. So higher expenses, therefore, should reflect that you're receiving more active management.

But how can you interpret whether the level of fees of any product is appropriate without understanding how much active management you are actually receiving in the product? And that's where active share comes in as a basic measure of how much security selection a fund is doing. So that brings up the active fee, which we define as the ratio of the level of expenses of the actively managed funds divided by the active share, the ratio of that.

In the paper, we define it more precisely as how much more expensive the active fund is relative to the passive fund, so the difference in fees over the active share. So it's, in my mind, a proxy for further rates or how much the active manager has to outperform by to earn back the higher fees that the fund charges. So maybe I can go through a very simple example.

So let's say an actively managed fund charges fees that are 100 basis points per year higher, it's just a simple example, than it costs to invest in the fund's benchmark. So then the further rate for that manager is that that fund needs to outperform by at least 100 basis points per year on average to earn back the higher level of fees. And then as just an example, say that the fund has an active share of 50%.

That means that half of the holdings of the fund are one for one overlapping with the holdings of the benchmark. Of course, it matters which holdings are overlapping. But the overlapping holdings themselves won't help to earn you back the higher fees.

As a simple example, and completely ignoring risk. Now, let's say both the fund and the benchmark have 5% invested in Apple stock, the same weights, then whatever the performance of Apple stock is in the markets, ignoring diversification risk for the moment, it will affect the fund and the benchmark identically because they have the same portfolio rates in Apple stock. So whatever Apple stock does is not going to help the manager earn back the higher fees.

So the fund can only earn back the higher fees to the extent that the fund is different than the benchmark. And so with an active share 50%, that's only half the portfolio. So you can then think about the further rates of the active part of the portfolio, the active share of the portfolio.

And that's why you divide the difference in fees by the active share to get the active fee, which in my very simple example, would be an active fee of 200 basis points per year.

Cameron Passmore: Exactly.

Ben Felix: Yeah, it's really interesting. It's the fee that you're paying on the active portion of the portfolio.

Is that a way to think about it?

Martijn Cremers: Exactly.

Ben Felix: So if you're paying an active management fee on a mostly closet index fund, you're paying a really high fee for the portion that's active. Yeah, that's interesting. Because you're paying active fees on beta for a portion of it, which means if you separate that out, the amount that you're paying just for active could be really, really high

Cameron Passmore: Yeah, that's it.

Martijn Cremers: It's also a way to compare fees across very different products. You always have to be careful with interpretation. At the first level, exactly as you said, I think of it as how much are you paying for stock selection?

If that is the main thing that the fund is doing.

Ben Felix: That makes a lot of sense how that could be very different across funds. Is there a relationship between fund size and closet indexing?

Martijn Cremers: Yes, but only for really large funds. And so many of the really, really large funds tend to have lower active shares or even low active shares. Their fees also tend to be lower.

So again, you have to adjust for that. But we did find that the very largest funds are more likely to be closet indexers. But if you take the very largest funds out, then we didn't find a strong relationship between fund size and closet indexing.

Cameron Passmore: And how do closet index funds perform compared to the more active peers?

Martijn Cremers: I think that's probably the main takeaway from our first active share paper. I think that's the strongest and most robust prediction I have is that closet index funds tend to strongly underperform with strong statistical significance. They typically underperform, if you form portfolios of closet index funds, by about the fees that they charge.

Ben Felix: That's interesting. Do I infer correctly from that, that research was less about active share predicts positive performance from high active share funds, but more so that it predicts negative performance from closet index funds?

Martijn Cremers: Yes. If you go back to our 2009 paper, we had a very strong statistical result on the low active share funds. We did have a result that the high active share funds as a group outperformed, but with much less statistical confidence.

Ben Felix: Wow. Okay.

Martijn Cremers: And then we had a third result, which I think is also a very robust result, which was that we found strong positive performance persistence among the high active share funds. So high active share funds that had strong outperformance in the past, that they were more likely to continue their outperformance in the future. So I think two of those three results, I think are fairly robust.

The one result that has not been very robust is that the average for the typical high active share fund outperformed. That was true for a particular time period that is not proven true since then or over the full period now measured.

Ben Felix: Okay. Interesting. So the strong performance of high active share funds in the sample in that paper looked pretty good, but out of sample, it has not been so good?

Martijn Cremers: Exactly. The other result is that the combination of high active share and strong past performance, that that leads to continued strong future performance that has been robust, as far as I know.

Ben Felix: Okay. Interesting.

Martijn Cremers: So it's the unconditional high active share. If you don't combine active share with anything else, then you don't find in recent decades that the average high active share fund has outperformed. But the positive performance persistence, as far as I'm aware of, has been robust.

Ben Felix: Probably related to persistence, how persistent is active share as opposed to performance, but active share itself?

Martijn Cremers: For a typical manager, active share is quite persistent. We look at five-year periods of time where the typical fund stays in its active share decile. So it's quite persistent.

There's some mean reversion, but very slow. Tracking error is much more strongly mean reverting. And so active share is quite persistent.

You see significant changes in active share when a fund massively changes its size. Typically, when its size goes up a lot, you see active share often, not always, but often come down a bit. And when the manager changes or the whole management team changes, you may see some significant changes in active share as well.

Ben Felix: Yeah. Okay. Interesting.

I was going to ask about that. With the Berk and Green 2004 idea that money flows to skilled managers to the point where they can no longer express their skill effectively. Is that that idea?

When a fund gets really, really big, its active share goes down?

Martijn Cremers: That is what we find. Yes. That is not a strong result unless the fund gets really big though.

Cameron Passmore: Okay. Empirically, how does active share relate to the three pillars of active management?

Martijn Cremers: Yeah. So in our paper I wrote in the Financial Analyst Journal, I tried to summarize what I have learned from doing research on active management. I put that together in what I call the three pillars framework that I argue summarize what I think active managers need for long-term success.

These are three things that they all need all at once. Not just two out of the three, you really all need all three at the same time. So they need skill, conviction, and opportunity, skill to identify investment opportunities.

Then the conviction to pursue an investment strategy that requires a certain courage of one's convictions, it's not easy to replicate. And then you need opportunity internally in the fund complex from your investors that you don't have too many constraints, but you also need to be operate in an external markets where you actually invest your cash, where there are actually investment opportunities. There are stock selection opportunities.

And then I relate those to active share. So for example, if you have a high active share, it doesn't mean you are a skilled manager. You don't need skill to have a high active share.

Active share is not a measure of skill. But if you have strong convictions, you would naturally have higher active share. If you have a lot of opportunities in the market for security selection, it is natural that you would have higher active share.

And so a high active share manager, in my view, will naturally be a manager with strong convictions and more opportunity, but not necessarily skill. But if the manager doesn't have skill and the markets are very competitive, then how long can high active share managers with strong convictions and opportunity, how long can they survive in very competitive markets? And that's why I say then in the end, well, if the market is really competitive and you have a manager with a high active share strategy that has good long-term performance, then that manager surely must have skill.

Ben Felix: Can you talk more about patience specifically and how important that is?

Martijn Cremers: Yeah, patience, I use it as my example for investment strategy that requires conviction. So if you go back to conviction, if a manager's active strategy doesn't require conviction, then why would it persist? Is the strategy successful?

And what prevents too much money from flowing in? What prevents too many other managers from doing exactly what this manager is doing? And so without the strategy requiring a certain courage upon convictions, where there are some economic frictions that you need to overcome, why would it persist?

Key example is Warren Buffett. It's actually very hard to do what he does. And so I think it's currently the case that especially in mutual funds, most investors evaluate their managers over fairly short periods of time.

And so it's a fairly impatient world. And so it's hard to be patient in an impatient world. There's a certain mismatch between the expected investment horizon of a patient manager and the time over which that manager is evaluated by the investors.

And even just hypothetically, let's say a patient long-term manager is right about a certain bet. That manager may be wrong about that bet in the short term, and he's evaluated by the investors in the short term. Then that mismatch creates an economic friction that makes it hard to be a patient manager and active.

If you look empirically, we find that most active managers are not very patient. They hold stocks for one to one and a half years on average. Most patient capital is not very active.

It's the combination of patients and high active share that is very rare. And so then if you think about markets where I posit, there are some long-term investment opportunities that only patient managers can exploit. And for reasons I just tried to explain, there's relatively few basic managers that pursue those because this is really hard to do unless you have really, really patient investors.

There may be particularly good opportunities for patient high active share managers.

Ben Felix: That gives me a follow-up question. You talked about the lack of persistence of the unconditional active share out of sample. If you look at patient high active share active managers, has that been persistent?

Martijn Cremers: Yes. The exercise that we did is we look at active funds in two dimensions independently, active share versus patients. What we found was that on average, the high active share managers did not only perform, but there was also no strong outperformance in our sample, except for the high active share managers that were also patients. So all of the outperformance also in my earlier study really came down to that group that is both high active share and patient.

The less patient high active share managers also did not only perform, so arguably may still be a decent starting spot to start with. But it was really the combination of patients high active share that on the one hand is rare, on the other hand, it drove the outperformance among the high active share funds.

Cameron Passmore: Interesting. I have to ask you, how was the active share concept initially received by both academia and the industry?

Martijn Cremers: So by now it's a fairly standard measure like tracking error. Initially, I think a lot of academics were very skeptical about our results because it goes against the grain of the conventional wisdom of active management. When we originally did our paper, we were so astonished of how many low active share or closet index funds there were in the market.

I think that in practice or in the industry, it has become a standard measure that is useful to, on the one hand, find closet indexers, but also on the other hand, find funds that actually do a lot of security selection. And there's lots of funds that do that. It's a very simple measure to find those funds.

Ben Felix: It definitely does go against the conventional wisdom. We've been beating the index funds drum for a long time at our firm. And yeah, this is definitely something that somebody who promotes active management can say, well, hey, look, there's this research that says that there are cases where it can make sense.

There's a critical paper in the Financial Analyst Journal, 2016 paper that I'm sure you're familiar with, deactivating active share. I'd love to know what you think about their critique.

Martijn Cremers: Yeah, it's good to have a debate. And I also was glad that they were able to replicate our original results without any problems. That's always a relief.

There can be issues with replications. If you go back to our paper, I talked about three big results. One, low active share funds with strong statistical confidence continue to underperform.

Then unconditionally that active share in our particular sample outperformed. That result did not prove robust over time. And then the third result is that if you combine high active share with past performance, we found strong positive performance persistence that in a recent Financial Analyst Journal we documented was persistent, and that was robust in the last couple of decades after our first paper was published.

And so this 2016 paper that you're referring to focus on the second of our two results, the one that has proven to be the least robust. They made a very important point that I talked about earlier, is that there's a very big difference in the typical active share of a large cap funds and a small cap funds. Large cap funds tend to have significantly lower active shares on average.

And most small cap funds have very, very high active shares. There's simply not much variation in active shares among small cap funds. Almost all are very high.

The real variation in active share comes from large cap funds. What they do in this paper is they then sort active share within the style. They sort on active share only within large caps and only within small caps.

And then they look at basically within style and then the aggregate, if that makes sense. So they do it sequentially. So they decide whether or not a fund is high or low active share within a certain style.

In my mind, that kind of confuses a bit what active share is trying to do. And then what they find is that, if I remember correctly, is that the main results that high active share funds outperform in that original sample, that is not robust once you adjust what active share means. And so effectively what it means is they are adding large cap funds with active shares that are actually not that high to the high active share group because they do it just within large caps.

And so in my mind, they're adding noise to active share and that weakens the results. But at the same time, it's a very important point that style matters for active share a lot and that if you're looking at a small cap fund, almost all of them have a very high active share. But I don't think that you can reduce active share to just style.

And that's also why I point to all of the other results about low active share funds significantly underperforming, which they also report, but don't talk about in their paper. And then the positive performance as well as a large range of other results in my too many papers I've now written in this field as well.

Ben Felix: There's a chart in a white paper from Vanguard showing increasing dispersion of benchmark relative performance with increasing active share. How concerned do you think investors who are seeking high active share funds, like they hear this podcast and say, cool, I'm going to go find a high active share fund, maybe a patient high active share fund. How worried should they be about that increasing dispersion?

Martijn Cremers: The increased dispersion among high active share funds is inherent. If you're dealing with a fund with a lot of security selection, then that fund is more different from the benchmark. And so you would expect that funds to be more likely to have returns that are different from the benchmark.

And that creates the dispersion. With all respect to Vanguard, I think of that issue as not really an issue about dispersion per se. I think of it as an issue of idiosyncratic risk first.

And when you think about what investors should be doing, I think investors should think about their overall portfolio, not the dispersion of idiosyncratic risk of a particular fund, but rather how, if you take your overall portfolio, what happens to your overall portfolio if you add or do not add that particular fund to your overall portfolio. And what you worry about is not the idiosyncratic risk of a particular fund, but how adding that idiosyncratic risk to the overall portfolio actually changes the dispersion in your overall portfolio. So where you don't like dispersion is in your overall portfolio.

But adding a fund with more idiosyncratic risk, as you may very well do if you add a high active share fund, may actually be good for diversification. If the fund that you're adding is completely different than anything else you have in your portfolio. I think that's what's missing from the Vanguard discussion.

They do not think about the overall portfolio. They don't think about diversification and how diversification can actually be improved by adding a product that has less overlap with what is already in the overall portfolio or more generally how idiosyncratic risk actually helps diversification.

Cameron Passmore: And further to Ben's question, Martijn, so we have listeners that range from a curious DIY type to a lot of experienced seasoned professionals who listen. So in your opinion, how should they decide whether to invest in index funds or to actually hunt for patient high active share fund that might beat the index?

Martijn Cremers: I don't give investment advice, but I appreciate the question.

Cameron Passmore: I knew the disclaimer was coming.

Martijn Cremers: Yeah. I have my usual disclosure as well that I serve as independent director of an active manager. If I would give advice, it depends on what you're trying to achieve and what you're trying to avoid.

If an investor is very focused on avoiding on the performance and they don't have time to study active managers and it makes sense to invest in low active share funds that are very inexpensive. I think there are one aspect that we haven't talked about is downside risk protection. And there's actually considerable evidence that we also go through in our challenging conventional wisdom paper is that active managers have real skills in risk management and particularly downside risk protection.

And if investors are very interested in that, but also are interested in potential outperformance, but they're also really worried about protecting the downside, especially in times that the market is not performing well, then they may consider high active share funds that have strong past performance, strong evidence track records of protecting the downsides in bad times over a longer period of time at a reasonable fee. But that takes research, that takes time, that is really not easy to do.

Ben Felix: But unlike the conventional wisdom, it's not a foregone conclusion. It sounds like based on your research that you're going to underperform if you try and choose an active fund.

Martijn Cremers: Yeah, that's my conclusion. As long as, again, it's a fund that is worth its fee, that's actually very different and not the closed index funds.

Ben Felix: All right, let's move on to your relatively recent paper on active share in fixed income, which is a really interesting concept. Can you talk about how the arguments in favor of indexing in equities hold up when we move over to fixed income?

Martijn Cremers: It's a completely different world we found. Yeah, we're excited. It's a new paper, taking a bunch of years to write, but I'm excited about it.

It starts with the observation is that passive funds, the actual passive funds in fixed income are actually not very passive. They don't actually follow the benchmarks very closely. The actual passive funds in fixed income or index funds, ETFs in fixed income, they have wealthy high active shares and they trade a lot.

And the reason for this is that other than in equities where very close replication of the actual benchmarks is fairly easy and low cost, it's not at all the case for fixed income. Benchmark replication is far from straightforward. Lots and lots of securities in fixed income that are in the benchmarks are very illiquid.

So it is practically impossible for a passive fund manager to closely follow the benchmark. The second broad point is fixed income markets are still much, much less efficient than equity markets. And the mutual fund industry, so to speak, is much less competitive.

Wealthy speaking. If you compare US fixed income to US equities, especially large cap equities, most of the money is.

Cameron Passmore: What are the main challenges for index investing in fixed income?

Martijn Cremers: The benchmarks in fixed income have too many securities. So many of these securities are fairly illiquid. For example, the main market wide benchmark of fixed income in the US is the Bloomberg US aggregate.

It contains more than 12,000 different securities. I think about half of those don't trade on any given day. So in general, many of these securities are not very liquid at all.

And that means if you are a manager of a passive fixed income funds, you face a real tradeoff that is not really faced by your equity counterparts. So a passive fixed income fund face the tradeoff between, on the one hand, tracking the benchmark. But on the other hand, you want to also control or really limit the trading costs and provide liquidity to their investors.

And it's really hard to do both. It's really hard to closely track, but do so at a low cost that provides liquidity to your investors.

Ben Felix: We had Hank Bessembinder on this podcast a while ago, pretty recently actually. And he talked about the performance of equity mutual funds at long horizons and how it gets worse and worse the longer you go out. How do active bond funds perform relative to index funds at increasing horizons?

Martijn Cremers: Bessembinder makes a very powerful argument for equity funds. I find his work very compelling. So it's again, it's very different for bonds.

The average active bond fund has outperformed their passive counterparts. Not by much and statistically significant is marginal. In our sample, look at a fairly large, long sample.

It's about 28 basis points per year with some, but not strong statistical confidence.

Cameron Passmore: And what explains that?

Martijn Cremers: Well, first as I elaborated, passive investing in fixed income is very difficult. Trading is very costly. On the other hand, fixed income markets are much less efficient and the industry there is less competitive than for US equities.

Ben Felix: You talked about how bond index funds don't really look like the index. How does the active share of a typical bond index fund look?

Martijn Cremers: The active share of bond funds is one of the things of course we do in our paper. We adjust it for the fixed income markets. So we compute active shares at two different levels.

The security level, which is the bond issue level, which is we can directly compare to the active share of an equity fund. Very few equities have more than one share class. But you can also compute the active share of a bond funds at the firm level or the issuer level.

For example, IBM Corporation issues many, many different bonds. So you can look at the IBM bonds at the issue level, or you can aggregate up across all the different issues that an issuer like IBM has issued and then calculate the portfolio weights at the level of the issuer, the firm. And then you first aggregate up the weights, you end up with two different active shares.

But the median passive bond fund has a bond level active share, so security level active share of 55%, which is incredibly high. And you can compare that to the median active share of a passive equity funds, which is about 2%. In other words, passive equity funds are actually really, really low active share, 2% median, while for passive bond funds, those are substantially different than their benchmarks.

Cameron Passmore: And how does bond liquidity affect bond index fund active share?

Martijn Cremers: If you look at where the active share of these passive index funds come from, then it comes primarily from them avoiding the more illiquid issues in their benchmark. And those are costly to trade, need to provide liquidity to investors, has a lot of turnover. And so they minimize costs by avoiding trading in some of the less liquid parts of the benchmark, which also, of course, that means they also have more tracking error that comes with that.

But doing that increases their active share and can explain why the median active share of the passive fixed income funds in our sample, including ETFs, is 55%.

Ben Felix: You talked about a couple of the reasons that it's different in fixed income than it is in equities. What about the skewness argument? That's one of the things that we talked to Hank Bessembinder about.

Does that apply in fixed income markets?

Martijn Cremers: It doesn't. I find Henrik Bessembinder's skewness argument very compelling. I think it's a very strong argument pertaining to equity funds.

In equity funds, distribution cross-sectionally of equity returns is very strongly positively skewed, that a few names, few stocks have extremely high positive stock returns. And those few names drive the performance of the market, drive outperformance. That's where the idea of buying the haystack comes from.

That outperformance requires that you to be in those names. And one way to do that is be very well diversified and buy the haystack. That argument of very strong positive skewness strengthens the diversification benefits of indexing of passive management.

We find that that argument simply doesn't apply to bonds. Bond returns are not very positively skewed. They have hardly any skew at all, especially compared to stocks.

So the positive skewness argument is simply moot. We repeat several of the exercises that Professor Bessembinder has done, and we don't find that it applies to bond markets. And for example, one of the things that he does in his papers is he chooses random stocks and see what is the percentage that a random stock will underperform, or you perform portfolios that are not super well diversified.

How many stocks does it take before this skewness effect wears out? So for equities, it requires, we're doing this for memory, but I think hundreds of stocks before this skewness effect wears out. And for bonds, it doesn't.

If you have 30 bonds, then the skewness effect is moot because the skewness in bonds is much less positive. And so the diversification argument, the skewness argument doesn't really apply to bonds.

Ben Felix: Yeah, it makes sense, I guess, because you wouldn't have big upside single bond issue for some reason.

Martijn Cremers: Oh, exactly. I've long thought fixed income, I think for 10 years at Yale, and I taught it at Notre Dame when I started here, and I always like to tell my students, bonds are very strange instruments. The best you can ever hope to get from a bond is exactly what it promises to pay you.

Cameron Passmore: Exactly.

Martijn Cremers: Of course, I'm not looking at any embedded options or convertibles. If you just look at a straight bond, then the best you can ever do is that bond gives you exactly the cash that it promises. In other words, the upside is strictly limited.

And just basically way down, then you may have a decent upside, but there's a strict limit to the upside. You still have the whole downside. And so that explains exactly why bond returns are much less positively skewed than equities, because equities don't really have an upside limit.

Ben Felix: Yeah, right. You implicitly answered this in answering the previous questions. Why do you think active bond funds have remained relatively popular despite active management declining in popularity within equities?

Martijn Cremers: Yeah, that was the starting point of our paper, where we just observed that empirically speaking, these massive outflows that we've observed in the active management industry for equities hasn't happened in bonds. And so passive investing in bond funds has also become more popular, but we've not seen the massive outflows out of actively managed bond funds. I think a lot of that is just about performance.

Active bond funds have performed fine. They have generally outperformed passive bond funds. Passive bond funds, as I explained, are actually not that passive.

And in our paper, we have a lot of results related to active share. We find that the high active share bond funds have done substantial outperformance. We found significant positive performance resistance among high active share bond funds.

And we also find that the high active share bond funds have significant protection on the downside. If you look at the maximum drawdown over last eight quarters, the high active share bond funds perform pretty well there. In other words, the case for active management in bond funds seems relatively strong.

Ben Felix: It's interesting. Anecdotally, Cameron and I have talked to peer firms like us, and it's not uncommon to find a firm that's really passionate about index investing within equities, but they are still using active management in fixed income, which I think speaks to the points you're making here.

Cameron Passmore: Our final question for you, Martijn, how do you define success in your life?

Martijn Cremers: That's a great question and a hard one. Well, what is success in life? I think for me, that's defined by a life that is full of faith, full of love, and full of hope.

And those are great gifts. And that includes, I would say, faithfulness to your particular vocation. For me, my vocation as a husband, to my wife, as a father, to our children, but also my vocation as a professor of scholarship, teaching, and administration.

At the end of the day, for me, faith, love, and hope are the three things that are hard to measure per se, but that do define success for me.

Cameron Passmore: What a wonderful answer. Great to meet you. Great to have you on.

Martijn Cremers: Thanks for having me. It was great. Thank you.

Ben Felix: Awesome. Thanks, Martijn.

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