Active Share vs Tracking Error

Does more active management lead to higher outperformance?

September 2025. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

• Active funds need to become active to justify their fees
• There is no relationship between being more active & outperformance
• Regardless if measured via active share or tracking error

INTRODUCTION

Fund managers are paid to outperform, which means they must differ from their benchmarks. For years, many could stay close to benchmarks, hugging them closely, but the rise of ETFs and improved analytics has made that approach harder. To justify meaningful fees, managers now need to be truly active.

Greater activity, however, is a double-edged sword: it increases the potential for both strong outperformance and significant underperformance. The most common ways to measure this activity are active share and tracking error.

This article explores how these two metrics influence fund managers’ ability to outperform.

ACTIVE SHARE & OUTPERFORMANCE

We consider all equity mutual funds and ETFs trading in the U.S. as our universe. For each fund, we algorithmically select an appropriate benchmark index and exclude any fund with an R2 below 0.7 relative to its benchmark, resulting in a universe of approximately 2,500 funds.

Next, we calculate each fund’s active share, which measures the percentage of holdings that do not overlap with the benchmark. For instance, a fund with an active share below 10% is considered an index hugger, as its portfolio closely mirrors the benchmark.

We then sort funds into decile portfolios based on active share and compute their average outperformance relative to the benchmark. While higher active share theoretically offers greater opportunity to outperform, we observe that the average fund underperformed and that there is no clear relationship between active share and outperformance.