Measuring how active managers actually are is a useful tool for investors. A metric called “active share” can be used by institutional investors to assess active fees, measure and monitor managers styles and maintain portfolio diversification. By Thusith I. Mahanama, chief executive of Assette.
Seven years ago, professors Martijn Cremers and Antti Petajisto introduced a new metric for determining which mutual fund managers were making active bets against their benchmark.
They called the new tool “active share” and went on to conclude that managers with an active share of 80 per cent or higher tend to outperform their benchmarks—after fees—and they do so with persistence.1
Since then, active share has been the subject of further research by Cremers, Petajisto and others. While there is some debate as to whether it can predict managers which are likely to outperform, there is one thing everyone seems to agree on: Active share is an excellent way to identify whether or not a manager is a closet indexer.
What is active share?
Active share identifies the extent to which a portfolio’s holdings diverge from those of the benchmark. The idea behind active share is simple: In order to beat the benchmark, a portfolio must be different from the benchmark. In order to be different, a manager must make active judgments, usually categorised as:
1. Holding securities that are not in the index.
2. Holding securities in the index, but overweighting the position.
3. Holding securities in the index, but underweighting the position.
4. Not holding securities that are in the index.
Active share is expressed on a 0 to 100 per cent scale. Index funds have an active share of less than 20 per cent, meaning 80 per cent of the portfolio overlaps with its benchmark. Portfolios with an active share of 80 per cent or more are considered quite active—only 20 per cent of their portfolio’s holdings mirror those in the benchmark.
The calculation for determining active share is:
Active Share = 100% -∑|Overlapping Weights [portfolio, i and index, i]|2
So, what percentage of active share should you look for in your managers’ portfolios? According to Dr. Cremers, the number varies by style. In a recent Wall Street Journal article, he said that an active share of at least 60 per cent is good. Large-cap managers should be in the 70 per cent-plus range; midcap managers in the 85 per cent-plus range; and small-cap managers should have an active share in excess of 90 per cent.3
Active share helps asset owners identify just how active their managers’ portfolios really are. For fiduciaries, active share can help fulfill three important responsibilities:
1. Ensure fund assets are diversified.
Knowing the active share of the fund’s equity managers can uncover portfolios that are converging close to the index, drifting away from their style mandate or otherwise affecting the overall asset allocation targets of the fund. Active share can be especially useful for very large funds with many active equity managers. Applied to the equity aggregate as a whole, active share can help assess whether the fund’s total equity exposure is delivering active value or morphing into an index-like portfolio.
2. Hire and monitor investment service providers.
Active share analysis can help fiduciaries identify and eliminate closet indexers from consideration during new manager searches. Ongoing active share monitoring can tell you whether your managers continue to deliver active value to the fund and maintain their conviction to their investment mandates. The four charts at the end of this paper illustrate various ways fiduciaries can use active share to monitor manager portfolios.
3. Determine whether investment fees are reasonable.
Active managers deserve to be compensated for their skill and judgment. But paying active management fees for a portfolio that is a closet index fund is unreasonable. Active share analysis helps fiduciaries quantify how active a portfolio is and make sure the fees they are paying are justified.
Assessing benchmark fit and style consistency
Active share stats are only as good as the benchmark used to evaluate a manager’s portfolio or a fund’s aggregate equity exposure. Fortunately, there are several ways to use active share to test a portfolio for benchmark compatibility and its slippery cousin, style consistency. The examples that follow illustrate several types of active share analysis that should give you all the ammunition you need to validate a manager’s active skill and their primary benchmark.
Active share gives fund sponsors powerful confirmation of a manager’s active contribution to returns.
Used in tandem with traditional measures like tracking error and r-squared, it adds depth and nuance to portfolio analytics by relying on a different set of observations. Finally, active share helps fund sponsors carry out their fiduciary duty to maintain a diversified fund, hire and monitor qualified investment managers, and make sure they are getting full value for the active management fees they pay.
Examples of using active share to analyze a manager’s active skill, benchmark fit and style consistency
One of the beauties of active share is its versatility. Here are a few examples of how asset owners use active share to evaluate new manager-candidates and monitor existing active managers.
1. Portfolio Active Share vs. Multiple Indices: Point in Time
This analysis looks at how a portfolio stacks up against the holdings of its primary performance benchmark, as well as the holdings of alternate benchmarks.
The idea is that a portfolio should have more in common with an appropriate benchmark index than it does with an incompatible one.
You would expect that a small-cap growth portfolio’s active share would be lowest against the Russell 2000 Growth Index, since it has the most overlap with that index. Conversely, its active share should be higher against less-appropriate benchmarks like the Russell 2000 or the Russell Mid-Cap.
By running an active share analysis against multiple indices, you can determine whether a manager’s primary benchmark is, indeed, the most appropriate proxy for their mandate.
Are your managers as active as you think they are? Are your managers as active as you think they are?
Let’s look at an example of how this analysis plays out in real life.
We’ll assume the manager in question is running an active small-cap growth portfolio. Their primary benchmark is the Russell 2000 Growth Index—index 1— in the chart above. Index 2 is the Russell 2000; index 3 is the Russell Mid-Cap Index; and index 4 is the Russell 2000 Value Index.
The portfolio has a very high active share of 93.3 per cent versus its primary benchmark. The active share against the other three indices gets progressively higher— indicating that the portfolio has more in common with the Russell 2000 Growth Index it does with the Small-Cap, Mid-Cap or Small-Cap Value index.
So far, so good for our small-cap growth manager. You now have point-in-time evidence that a) their portfolio reflects a small-cap growth bias and b) the Russell 2000 Growth Index is an appropriate performance proxy for this portfolio.
2. Portfolio Active Share vs. Multiple Indices: Time Series
As the graph above illustrates, things get even more interesting when you look at active share against various benchmarks over time.
Time series analyses reveals patterns of portfolio behaviour. Portfolios that consistently demonstrate the lowest active share versus their primary benchmark are likely dedicated to their mandate and managed through a disciplined investment philosophy and process—an important consideration in manager selection and retention.
The thick blue line denotes this portfolio’s primary benchmark index, index 1.
As you can see, this hasn’t been the one with the lowest active share in the past, but the portfolio has recently begun to align with its primary benchmark. Is this the best benchmark for this portfolio? Did the manager change style or let the portfolio drift? Is there something else at work here?
Perhaps the portfolio’s strategic mandate changed during the period covered by the chart, or reallocations of cash into or out of the portfolio temporarily disrupted the manager’s investment discipline.
Both could explain the early periods of misalignment with the primary benchmark. Structural changes to the composition of the benchmark index can also create misalignments, although these tend to be shorter-term anomalies that smooth out over time.
Of course, perhaps the portfolio simply has a history of style drift.
No matter what the rationale, having access to historical active share information against multiple benchmarks talk to your managers about how exogenous factors affect the portfolio, the discipline of the manager’s investment process and their commitment to their mandate.
3. Active Share vs. Style Indices: Consistency over Time
This analysis lets you use active share/multiple indices analysis in a slightly different way, one suggested in the original research by Profs. Cremers and Petajisto: Tracking the style of a portfolio over time.4
Based on a specified set of colour-coded indices, the chart above identifies the index with the lowest active share at the end of each time interval.
The portfolio is determined to “belong” to the style represented by the index with the lowest active share. If the colour remains the same across all intervals, it indicates the portfolio has been consistent in its style and/or investment approach.
As an example, let’s say you have a small-cap growth manager whose primary benchmark is the Russell 2000 Growth Index. For the purposes of this chart, you specify the following indices and colors:
R2000 Growth Small-Cap Growth Pink
R2000 Small-Cap Green
R2000 Value Small-Cap Value Gray
Russell Mid-cap Mid-Cap Blue
The portfolio has had the lowest active share to the Russell 2000 Growth Index in all but two periods displayed in the chart.
Those intervals may be anomalies, or due to index reconstitution, or perhaps they signal a change in the manager’s investment approach. Overall, it appears that the primary benchmark has been appropriate for this portfolio.
But there is more to be gleaned here.
Using the indices as a proxy for style, this portfolio has been remarkably consistent in its adherence to its small-cap growth mandate.
Even when its active share trended toward the Russell 2000, it was still a small-cap portfolio, albeit one with a less pronounced growth tilt—something that could be explained by a change in the composition of the indices themselves.
Not only does the Russell 2000 Growth Index appear to be an appropriate benchmark for this portfolio, but the manager has also been consistent in sticking to their assigned mandate over the period of the analysis.
Armed with these active share analytics, you can now determine just how active a portfolio is, whether its benchmark is appropriate, and how consistently a manager’s investment process stays true to their style mandate over time.
1 Cremers, Martijn, and Petajisto, Antti. 2009. “How active is your fund manager? A new measure that predicts performance.”
2 This formula is an alternative to the original formula presented in the 2009 paper cited below. In personal communications between Dr. Martijn Cremers and Thusith Mahanama, CEO of Assette, on 1.8.14, Dr. Cremers stated that he now prefers this alternative formula for active share.
3 Light, Joe. 1.18.14. “And the Next Star Fund Manager is . . .” Wall Street Journal. Retrieved from: http://stream.wsj.com/story/latest-headlines/SS-2-63399/SS-2-429840/
4 Ibid. Cremers and Petajisto. 2009.