12:38 pm ET
Aug 25, 2014

My “Intelligent Investor” column last weekend on the fall of stock-picking drew a flood of comments and emails. Many readers seem to think that active funds are in a state of temporary underperformance relative to index funds.

But the data would suggest, instead, that active funds are in the midst of a worrisome long-term decline.

A measure called “active share” captures the extent to which a fund manager’s selections differ from those of a market index. The higher a fund’s active share, the more boldly its manager is deviating from the benchmark. A U.S.-stock fund that owned absolutely nothing in an index like the S&P 500, for example, would have an active share of 100%; an index fund that perfectly replicated the holdings of the benchmark would have an active share of 0%.

In 1980, according to Martijn Cremers, a finance professor at the University of Notre Dame, active share averaged roughly 37%; by mid-2012, it had shriveled to 23.1%. It has since rebounded, but only slightly, to 26.6% at year-end 2013. (He compared U.S.-stock funds with the Russell 1000 index.)

Fund managers and fund investors don’t face exactly the same risks. Mutual funds are a lot like flypaper: Whatever lands there tends to stick there. So, once assets pile up, fund managers have little incentive to try to beat the market with gutsy stock picks. The investors they already have in the fund are likely to stay there unless performance suddenly turns terrible. That, in turn, is likely to happen only if the fund manager does something drastically different from the market as a whole. So, while fund investors might want their funds to outperform, many fund managers want their funds to perform only well enough to keep money they already have from leaving.

Prof. Cremers isn’t sure why active share has ticked up a bit lately. Perhaps the enormous 32% return of the S&P 500 in 2013 gave active managers some freedom in which to wander away from the benchmark; after all, if doing so led them to underperform by a few percentage points, investors in their funds would still earn returns of 25% or more and thus have little reason to leave. Or, perhaps, investors and fund managers themselves are “becoming more aware of the importance of actively managed mutual funds being more distinct,” he says. It’s too soon to tell for sure.

But even at 26.6%, active share is barely above its lowest levels on record. Note carefully what this means: not just that the performance of actively managed funds has been relatively poor lately, but also that the portfolios of actively managed funds are no longer being designed to look very different from their market benchmarks.

If active stock-pickers are going to prove their worth, they’d better start getting a lot more active—not by trading more, but by looking different from the indexes they are trying to beat.