Numerous surveys suggest that Australians are not completely satisfied with superannuation as it exists today.

First, fund members tend to think that they will not have enough to retire and second, that investment plan providers are not necessarily acting in their best interest.

In this context, we asked in a recent study supported by AXA Investment Managers whether the recent rapid development of self-managed superannuation funds (SMSFs) may be related to the level of dissatisfaction with the more mainstream types of pension funds (retail, industry and non-profit) especially amongst the relatively more financially literate and wealthier segment of the population.

The original attractiveness of SMSFs springs from tax incentives available to wealthy individuals and small business owners.

But today it can be argued that if Superannuation funds, especially default option embodied by the MySuper legislation, gave individuals a clearer and more explicit vision of what their pension savings are invested to achieve at the relevant horizon, a number of well-off middle class households would not feel compelled to switch to a “do-it-yourself” version of pension wealth management.

This trend may be seen as symptomatic of the difficulty for an industry to demonstrate the benefits of delegation, leading a group of the more active and engaged members to take matters into their own hands.

 

Developing a reporting standard

 

While more financial education of individual members is necessary, the objective cannot be one of making each individual member a specialist of long-term pension investment.

Moreover, behavioural biases are likely to prevent even the best informed from optimally managing their pension savings. If education can only play a limited role and delegation is necessary, the quality of reporting (i.e. what performance information pension investment solutions providers return to their members) is an essential dimension of the credibility of the pension system as a whole.

Existing reporting requirements leave individuals faced with the problem of computing the contribution of a particular investment option to their pension investment objectives by themselves.

The current debate between industry and regulator about the most useful type of reporting will continue so that innovation and learning can take place, while minimising the burden of compliance costs. Part of this effort can come from superannuation funds themselves and the leadership of major providers is important in this regard.

Regulatory effectiveness and regulatory costs could be optimised by developing a reporting standard of only the most relevant information for fund members. This standard, we argue, can only be developed as part of an iterative dialogue between industry and regulator and pension solutions providers should lead it.

 

Certifying solutions

As well as transparency and the role of reporting, the ability of a pension system to apply sound governance principles is an important criterion against which it may be judged. Australia has long been in line with most OECD guidelines for fund governance. With the exception of self-managed pension funds, super funds are structured around trustee arrangements by which there is complete separation between members and trustees, who have fiduciary obligations and take ultimate responsibility for the fund.

A further industry-led step in the direction of good governance and transparency is the establishment of a governance body to oversee standards for the industry. To support innovation in the pension investment sector in Australia could be the creation of a certification scheme for retirement solutions compliance with generally accepted / best retirement investment and risk management and governance practices.

Such a scheme could be created by the industry to inform the default option selection work of the Fair Work Commission, but also signal service quality to individual investors and employers.

 

Better information and possibility of choice

 

Over the past decade, the super sector has been characterised by both increasing fund sizes, which should lead to scale economies that, in turn, should translate in lower costs for members. At the same time, the presence of a significant number of smaller funds also preserves the possibility of competition.

The premise of recent reforms of superannuation is that with better information and the possibility of choice, competition can play its role to improve the quality of service and the adequacy of pension investment products. However, increasing competition through member choice has not been associated with a dramatic decrease of costs, and the impact of economies of scale has also been muted.

Studies of the relationship between fees and investment performance suggests strongly that super funds with higher costs do not generate a consistently higher investment return.

The literature also finds an inverse relationship between costs and active performance and concludes that higher expenses cannot be justified with claims of more active management aiming, successfully of not, to achieve superior performance, especially in the case of retail funds.

When institutions allowing market participants to compete without restriction on prices or volumes are in place and the expected benefits of competition do not materialise, market mechanisms can be considered to be failing.

The Australian super sector is large and not dominated by any particular provider. Nevertheless, neither choice nor scale appears to have had a marked effect on prices (costs) or the relationship between prices and service quality and adequacy.

 

Adequate default option

The current problem faced by the average super fund member, as well as the regulator, is one of identification of the most desirable investment solution. The possibility of choice and the potential for competition have not yet been sufficient conditions to reveal what the advanced service providers could offer.

With perfect information about what investment solutions can be created to achieve a set of long-term objectives, competition between fund members would work as expected: individual members exercise choice and decide which solutions are best suited to their needs e.g. a real consumption/wealth target (liability) to be achieved at different points in their lifecycle while respecting a certain risk budget.

The difficulty arises from the absence of information (i.e. reporting) and point of reference (i.e. certification) for fund members, who cannot discriminate between providers. In this setting, efficient plan providers have an incentive to mimic inefficient providers (moral hazard), make no costly effort to design advanced investment solutions and provide the same products as inefficient providers. What drives up costs in this case is not the absence of competition, but the tendency for all providers to “pool” and behave like the inefficient type of service provider.

To avoid this pooling equilibrium, market participants can create “sorting devices” or “revelation mechanisms”. In this context, we note that consultants may play an important role in reducing asymmetrical information and that progress in this respect progress should be encouraged.

In their role as gatekeepers, consultants can for example challenge providers to improve reporting along lines that would be consistent with state-of-the-art principles for retirement management, and to redesign products to add value.

In the end, either individual pension fund members, through the regulator, can request bids for a limited number of pre-defined investment solutions (i.e. the regulated default option) in an auction, or pension plan providers can choose to highlight the different solutions that are available through the kind of reporting standard and certification scheme that we discussed above.

 

Designing high-quality default options

Whether auctions or certification is used to determine the most adequate default option in a defined contribution system, the question of what the optimal default fund should be is extensively discussed in the literature and its conclusions tend to be in contrast with the content of existing investment products.

The question with default options is to determine whether or not they should be standardised and, if necessary, regulated, which amounts to asking if on average the combination of a given set of asset allocation strategies and risk management techniques tends to deliver superior outcomes.

Improving the performance of default options in superannuation plans could begin with maximising the benefits of diversification both within and between asset classes, to design better performance portfolios to allow more ambitious targets at different levels of risk tolerance.

Likewise, better liability-hedging portfolios would reduce the risk of dispersion around the objective at the horizon and allow for a higher allocation to the performance portfolio at a given level of risk tolerance.

Going beyond a static liability-driven approach, dynamic allocation between the performance-seeking portfolio and the liability-hedging portfolio can recognise the time-varying nature of asset and liability risks and advantage of the mean-reversion of asset prices over the investors’ long-term horizon.

Without short-term downside protection included in their investment products, fund members are exposed to drastic losses when risky assets plummet simultaneously, as has been the case in the recent financial crisis.

Such insurance can be complex and costly to manage, yet a pension system aiming to rely on individual DC funds should aim to integrate the third pillar of risk management into its default option.

Indeed, the separate management of long-term liability risks (via hedging) and short-term loss aversion (via insurance) allows the investor to optimise risk taking in a dynamic manner over the investment period.

The latest advances in risk and investment management can be used to design a new generation of retirement products that would not only offer better performance and risk control features, but also more risk customisation.

In this context, the definition of advanced lifecycle benchmarks (representing reasonable partitions of the population of members according to investment horizons, short- and long-term risk aversion, etc.) would support the design of adequate default options would support convergence towards better default options within MySuper.

Lifecycle investment benchmarks would promote performance and innovation in this market. Providing information about reference asset allocation, they would be combined with generally accepted investment benchmarks to generate performance figures that could be presented using the standardised reporting framework discussed above, to serve as references for the industry.

 

Obsolete distinction between “pre” and “post” retirement

Australian retirees are likely to spend several decades of their lives in the “post-retirement” stage and the generation of adequate income to fund their desired level of real consumption over such periods should be integrated in the broader question of individuals’ asset and liability management over their entire life.

In effect, the period of retirement has its own stages, characterised by different consumption needs and risks, which would benefit from a lifecycle approach.

Crucially, the retirement of one’s human capital, the end of labour income, is the largest but also the most predictable asset allocation shock in one’s lifetime. We argue that an integrated, whole-lifecycle approach can thus improve wealth outcomes if this predictable shock is taken into account.

The choice of horizon at which labour income ceases could conceivably be managed as a variable in a dynamic lifecycle environment.

The standardisation of reporting and the provision of planning tools to members could allow the impact of financial, career and lifestyle decisions on retirement preparedness to be simulated, and even accommodate the de-regulation of the pensionable age and members’ increasing freedoms to transition out of the labour force.

Given the high expected inflation of the costs of healthcare and long-term care, savings accumulated until retirement risk being insufficient to cover these predictable expenses for a significant share of members.

Neither would a typical life annuity be indexed on healthcare price inflation. It thus follows that a proportion of individuals’ savings should stay optimally exposed to rewarded risk for a much longer period than the official retirement date currently suggests.

Since Australian pensioners are still exposed to investment, inflation or interest rate risk when they retire, and as they face a multi-decade liability/consumption objective with a likely upward slopping profile (a significant proportion of medical costs are incurred in the last years of life), they can still benefit considerably from applying efficient and targeted asset and risk management techniques to their pension savings after they have retired.

The most adequate investment horizon in the super system could thus be a function of individual member’s life expectancy, not the age from which they cease to receive labour income.

Hence, default options under MySuper could be designed to encompass the entire lifecycle of fund members and use several significant investment horizons including the official retirement date (the end of labour income) but also the stochastic horizon implied by life expectancy and longevity risk.

The investment and risk management technology described above remain the proper way to address this problem: optimise diversification benefits through the design of efficient building blocks, dynamically manage a combination of performance seeking and liability hedging portfolios to target long-term liabilities/wealth objectives taking into account not only age and risk preferences, but also changing market conditions, and control risk budgets through insurance mechanisms.

 

Frederic Blanc-Brude, research director, EDHEC Risk Institute—Asia, and Frederic Ducoulombier, director, EDHEC Risk Institute—Asia

G20 financial ministers and central bank governors welcomed the findings of the G20/OECD roundtable on institutional investors and long-term investment last month, which included clear plans to incentivise institutional investors to undertake more long-term investments.

The roundtable, “From solutions to actions: implementing measures to encourage institutional long-term investment financing”, held in Singapore recognised that long-term investment in infrastructure will contribute to global efforts to return to self-sustaining growth, and that institutional investors can help fill the finance gap. The key issue, the roundtable discussed, is the intermediation of available private capital into infrastructure.

Key messages raised by participants during the roundtable included that to incentivise institutional investors to undertake more long-term investments, performance measurements and compensation should be based on longer-term metrics and should not be penalised for short-term market fluctuations.

It was suggested that inflation-linked debt is an attractive asset class, and that introducing instruments that have a clear and explicit link with inflation would contribute to the better matching of assets and liabilities for pension funds.

While it was recognised that as traditional financing sources such as governments and banks become increasingly constrained and institutional investors can fill the financing gap, participation of non-bank private capital in infrastructure financing is hindered by the different interests of the various stakeholders in the project loan market.

To bridge the different needs and risk appetites, it would be efficient if capital could be “right-sighted”, so that commercial banks can finance projects at the construction stage, while institutional investors take over post-construction projects with stable cash flow.

It was also discussed that accounting standards can play a role in enhancing transparency, an essential part of attracting finance, and helping investors make informed decisions about long-term investment.

Some investors view current regulatory and accounting treatments as favouring mark-to-market accounting and low risk liquid assets instead of long-term investments.

Participants included delegates from G20/OECD Taskforce, IIWG delegates, B20 sherpa and representatives, IOs and senior representatives (CEOs/CIO) from institutional investors including the largest SWFs, pension funds and insurers, but also asset managers and banks. Leaders of the  G20 asked their finance ministers at their meeting in St Petersburg in September 2013 to identify approaches to the implementation of the G20/OECD high-level principles on long-term investment financing by the next leaders meeting, which will be in November 2014 in Brisbane, Australia.

 

The Fiduciary Investors Symposium, to be held on campus at Harvard University on October 26-28, will address the barriers investors need to overcome to invest more in long-term investments. Speakers at this session include:

Jane Ambachtsheer, global head of responsible investment, Mercer

Sharan Burrow, general secretary, International Trade Union Confederation (ITUC)

Raffaele Della Croce, lead manager, long-term investment project, OECD

Conor Kehoe, senior partner, McKinsey

Jameela Pedicini, vice president, sustainable investing at Harvard Management Company

Fiona Reynolds, managing director, PRI

Ethiopis Tafara, vice president and general counsel of International Finance Corporation, a member of the World Bank Group

Chair: David Wood, director of the Initiative for Responsible Investment at Harvard University

 

Long-horizon investors can withstand macro-economic volatility and so should tilt towards strategies that are exposed to that, including value, small cap and momentum. Oleg Ruban, vice president in the applied research team at MSCI says this validates factor-investing and factor-based asset allocation for these investors.

 

Appropriate asset allocation requires explicit attention be paid to the different problems, risks, horizons and constraints of different investors. It’s part of the evolution of modern asset allocation which has moved from equal weighting, risk weighting and risk parity through mean-variance and Black-Litterman reverse optimisation through to a more modern dynamic approach that includes looking at tolerance for macro-economic risk.

Unlike a more traditional approach which says most investors should invest in a similar way, outcome-oriented investing says the way to build a portfolio is to blend the components.

“You start with a market portfolio, and tilt away from the market depending on the different horizons and risks of the investors. The tilts can come from factors, pure alpha or skill and from risk hedging,” Ruban, who focuses on portfolio management and risk related research for asset owners and managers, says.

The commonality among institutional investors is they have a long horizon relative to the average investor which alters their risk tolerance.

Ruban expands that to explore the notion of risk versus uncertainty, and differentiates risk as being inherent in a current opportunity set and uncertainty being how that evolves over time.

“This uncertainty relates to macro economic risk and gives us the idea that long-run horizon investors are more tolerant of macro economic shocks because their time horizon means they have an ability to withstand these.”

From an asset allocation point of view, Ruban says this leads to whether there are strategies naturally more exposed to macro-economic fluctuations versus those that hedge those fluctuations.

“Institutional investors should tilt to those more exposed to fluctuations. A lot of traditional quant factors like value and small cap, and some behavioural strategies like momentum have greater sensitivity to fluctuations in economic growth versus the broad market. This leads to the idea long-horizon investors would want to tilt more to these risk premia strategies than short-horizon investors.”

This in turn, validates the idea of factor investing and factor-based asset allocation.

At the end of last year MSCI conducted a global asset owner survey which asked investors about their asset allocation practices and factor investing.

“The majority of participants believe factor investing can capture alpha,” Ruban says. “Ideologically there was an appreciation for factor-based asset allocation but people were still struggling with implementation.”

Ruban says there have been large institutional investors such as the Norwegian Sovereign Wealth Fund, CalPERS and Alaska Permanent Fund adopting factor-based asset allocation and he sees the trend continuing.

“More investors will follow. While there are some operational difficulties in implementation, the trend will continue,” he says.

Identifying the factors to use in asset allocation is part art and part science, he says, noting that organisational considerations play a role.

For example Alaska has identified “companies” as one of its factors and includes in this equities, private equity and corporate debt.

“There is some logic in that there is commonality but there is also some evidence that corporate debt behaves differently to equities at certain times. There is a statistical aspect to factor investing but it is also driven by certain organisational beliefs.”

Ruban says one of the main obstacles to more investors adopting factor-based asset allocation is the need to access the right technology in order to decompose the portfolio and view it through a factor lens.

“The main advantage of doing this is it gives you more detailed insight into what’s driving your portfolio,” he says. “In times of uncertainty factor-based behaviour can be more intuitive than asset class behaviour.”

The MSCI asset owner survey revealed an average asset allocation to listed equities of 38 per cent, but a risk contribution from equities of 92 per cent.

“Equities is more volatile and correlated so the risk contribution is quite high. But this doesn’t tell you much about the underlying structure of these risks, or factors you are exposed to and whether you believe in them or not.”

Factor-based asset allocation allows you to act at a more granular level.

Ruban says there have been some secular trends since the GFC, including investors in South East Asia changing the structure of their portfolios to be more international and investors in Japan adding more risk.

“Acess to factor-exposure analysis informs these decisions.”

Keith Ambachtsheer’s lead article in the Fall 2014 edition of the Rotman International Journal of Pension Management, takes readers through an historical and logical journey that supports the case for long-termism. Importantly he validates this with four high-profile investor case studies which demonstrate that a long-term view benefits society but also the investors, willing to practice it, in the form of higher returns.

In his article, The Case for Long-Termism, Ambachtsheer examines the historical journey of how mankind has shifted from subsistence societies to wealthier, more stable ones, arguing we are not there yet – there is still a higher plateau of civilisation to aspire to.

“Without long-termism we would still be living in the same subsistence societies our forebears did, continually on the edge of starvation,” he says.

“Surely it was our discovery of the wealth-creating logic of shifting from a mindset of day-to-day survival to one that stretched out to next week, next month, next year.. .and eventually out decades and even centuries. It was this shift towards being able to think and invest in ever longer time frames that made possible the eventual transformation of the subsistence societies of long ago to today’s far wealthier, more stable ones.”

The article goes on to address the fact that today’s societies are far more complex than the societies of long ago and because of this complexity, agents dominate in politics, corporations and finance. And in this world long-termism is not the dominant investment paradigm.

The principal/agent asymmetric information problem is not new in finance, with Ambachtsheer pointing out that Adam Smith addressed its existence in the “first opus on capitalism The Wealth of Nations”. But nor is it going away, and as such needs to be addressed.

Recent academic and practitioner writings on the problem, Ambachtsheer says, conclude that agents too often make business and investment decisions that favour their own short-term interests today, and that principals, or the fiduciaries acting on their behalf, must become more pro-active in fostering decisions that focus on longer-term value creation in their investments.

Part of the solution may lie in insisting that the representatives of asset owners become true fiduciaries, legally required to act in the sole best interest of the people to whom they owe a fiduciary duty.

“The resulting message to the governing boards of pension and other long-horizon organisations.. .is that they must stretch out the time horizon in which they frame their duties, as well as recognising the interconnected impact of their decisions on multiple constituents to whom they owe loyalty.”

Ambachtsheer’s call to action is that the “logical implication of these developments is that the individual and collective actions of the world’s leading pension funds are our best hope to transform investing into more functional, wealth-creating processes”.

The second part of his article gives four different and equally persuasive case studies – John Maynard Keynes managing the Kings College endowment, Warren Buffett’s Berkshire Hathaway, MFS Investment Management, and Ontario Teachers Pension Plan.

Each of the case studies is worth a read, so I won’t ruin it by trying to summarise, however the common threads through each are worth highlighting. For one, they see being out of step with the short-term mainstream as not only acceptable but a competitive advantage.

With MFS and OTPP, Ambachtsheer identifies three further common threads:

  1. Autonomy to act: the organisation does not have to compromise its long-term strategies to serve multiple master with short-term mindsets
  2. Governance and management quality: the organisation’s board can ask the right, hard questions, and its senior executives have good answers to them; both groups are committed to creating long-term value for their beneficiaries/clients.
  3. Human capital: attracting and retaining people committed to executing long-term investment strategies is the organisations number one success driver. This means thinking hard about selection processes, using long-term incentive structures, and creating a collaborative culture and working environment.

For those that see the benefits of long-termism, and need a path to fruition, that says it all.

 

For the full article click here

 

 

 

Generic strategies designed to harvest a certain factor premium regularly conflict with other factor premiums. We find that the premiums associated with these strategies tend to shrink, sometimes even to zero, in these periods of factor disagreement. Enhanced factor strategies, on the contrary, are explicitly designed to avoid stocks that are unattractive on other established factors. As a result, we find not only that their added value is higher on average, but also that they continue to deliver when generic factor strategies struggle. Read more about this white paper.

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

Fiduciary responsibility

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.