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.

 

A number of large institutional investors, including AP1, the Environment Agency and AustralianSuper, made changes to their strategic asset allocation as a result of Mercer’s 2011 study on climate risks, and now the consultant is working with a new raft of investors to assess forward-looking climate change scenarios against their current allocations. Meanwhile one of the world’s largest investors, APG, announced at the United Nations Climate Summit in New York earlier this week that it wants to double its investments in sustainable energy generation.

According to Mercer, traditional approaches to modelling strategic asset allocation fail to take account of climate change risk, primarily because they rely on historical quantitative analysis.

A number of funds have made allocation changes as a result of the work on climate risks that Mercer has done, including the Swedish pension fund Forsta AP-fonden (AP1) which has strengthened its share of real assets in the portfolio, including allocations to agricultural land and timberland. It is also looking at real estate and infrastructure opportunities.

According to Helga Birgden, partner at Mercer in Australia and lead on the 2014 Mercer climate change study, AustralianSuper also undertook a detailed analysis of its infrastructure assets, equities assets and property assets. Further more than half of the investors involved in the initial study changed the process for strategic asset allocation to include a discussion of climate change risk factors.

The 2014 asset allocation study incorporating climate risks, will again assess forward-looking climate change scenarios against the current asset allocation of investors with combined assets of $1.5 trillion.

The investors, which include New Zealand Super, AP1, CalSTRS, the Environment Agency Pension Fund, WWF-UK, and Cbus, will also get advice on how to make their portfolios more resilient to the financial risks posed by climate change.

In addition to Mercer, NERA Economic Consulting will be involved in the study, drawing on the world-recognised expertise on the economics of energy and environmental policies to develop the scenarios and assess their potential impacts on geographic regions and sectors, analysis that will be grounded in the climate change modelling literature.

Scenario impacts will be supplemented with analysis on the physical impacts resulting from climate change over the coming decades by Guy Carpenter, through in depth knowledge of a range of climate perils, such as flooding, hurricanes, and droughts.

Based on the scenario impacts developed by NERA and Guy Carpenter, Mercer will model the potential financial effects on key asset classes, regions and sectors.

Each client will receive a tailored report applying the modelling to their investment portfolios by the end of this year. The final global public report aims to launch in about March next year.

Birgden was in Montreal with other Mercer partners this week, making a decision on the final scenarios to be assessed – they are derived after a literature review conducted by NERA with detailed economic impact data available.

“They reflect plausible outcomes with respect to climate change policy and climate change damages and differ based on major policy and scientific variables and uncertainties. The approach will be to consider both sufficient “near-term” differentiation between the scenarios from 2015 through to 2050,” she says.

Brian Rice, a portfolio manager at CalSTRS addressed the fact that traditional asset allocation models don’t take account of climate risks, and said in a statement that the multi-scenario, forward-looking approach makes the study unique.

“Investors will be able to consider allocation optimisation, based on the scenario they believe most probable, to help mitigate risk and improve investment returns.”

Meanwhile APG executive, Angelien Kemna, announced at the United Nations Climate Summit in New York earlier this week that APG wants to double its investments in sustainable energy generation from €1 to €2 billion.

Kemna, who speaks on behalf of a coalition of nearly 350 institutional investors and financial institutions, notes that in 2013 around $250 billion has been invested in clean energy solutions worldwide. To counter the worst effects of climate change this amount should be doubled within a few years.

The doubling of investments which APG wants to achieve in the next three years, for example in wind and solar power, fits the focus on sustainability in APG’s investment portfolio.

In her speech Kemna announced that APG has managed to double its investments in sustainable real estate to €11 billion in the past two years, important because real estate is responsible for 40 per cent of all greenhouse gas emissions worldwide.

She said that in order to facilitate sustainable investing for pension funds and institutional investors, it is important that governments ensure clear and stable regulations. This involves measures such as the elimination of fossil fuel subsidies, higher prices for CO2 emission rights and increased support for research into cleaner energy.

To underline the importance of this, APG, together with other investors, has signed a statement on climate change in which governments are asked to take such measures. The statement is endorsed by 347 investors, including Dutch pension funds ABP, bpfBOUW, SPW, PPF APG and insurance company Loyalis. They announce their ambition to look into investments with low CO2 emissions, to the extent that this fits within their task as a pension provider and insurer. They also will encourage companies in which they invest in to be clear and open about the risks they face from climate change.

 

Factor investing is becoming more popular. Professional investors are increasingly considering investing strategically in certain parts of the financial market which realize better risk-adjusted returns over longer periods. The question is: “How can investors best implement this strategy?”. Read the full article.

AP4 already has US and emerging markets low-carbon mandates and plans to invest up to $1 billion across various regions. Mikael Johansson, senior portfolio manager global equities, AP4 explains how the concept of responsible investment can be integrated into the investment process of a large pension fund and the challenges in implementing low carbon mandates.

 

Our starting point is the position that climate change is one of the largest threats to the environment that we have and it concerns a large proportion of all the companies on the stock market and therefore we see it as one of the largest ESG risks.

The premise that according to the inter-government panel on climate change IPCC there is a limited risk in the long term may then damage the global economy with persistent poor growth.  And AP4 believes this will impact pension funds’ ability to achieve their long term targets.

“We believe that it’s is likely that we will see significant increase in the cost structure of carbon emissions. This will change the relative competitiveness between companies. Our expectation is that the companies with less carbon emissions than their competitors will have an economic advantage and will have a better value performance. We see it as an investment opportunity to avoid companies that are going to suffer the most due to the increased cost of carbon emissions. Our belief is that the value of those companies will be worse,” he says.

Based on these beliefs in early 2012 AP4 started a project to develop and invest in a low carbon strategy.

Importantly as a universal owner one of the requirements were that it wanted to have full market exposure.

AP4 also decided that the mandate should have a low tracking error to a standard index. And it should have a significant carbon reduction – at least a 40 percent reduction compared to the standard index.

“Also…we needed a suitable portfolio structure for the mandate. And a final objective was that the mandate should be open to other investors in order to make low carbon investment more available. So we set up a fund with together with an external manager.”

The total investment in low carbon mandate is 7 per cent of global equity portfolio and the target is to increase that.

“Our first low carbon fund was completed in November 2012 based on the S&P 500 and we now have $580 million invested in that fund.  In 2013 we continued to develop a low carbon mandate in emerging markets based on the MSCI index. And our current investment amounts to $570 million. We are currently working to make new investment in the Pacific and Europe before the end of 2014. “

The two mandates are based on two different methodologies.

The basic idea is to exclude companies with high relative carbon emission from the benchmark and to optimize the remaining stocks so as to minimize the tracking error against the original benchmark.

“We are trying to isolate the carbon price risk so it would be a passive mandate but with a low exposure to carbon price. In the USA the starting point is the S&P 500. The constituents are ranked by their carbon footprint which is defined as the company’s annual greenhouse emissions divided by annual revenues,” he explains.

“We use revenues to normalize carbon footprint in order to avoid size effects in the screening. The 100 companies with the highest carbon footprint are excluded but the exclusions in each sector cannot exceed 50 percent of the original sector weight. The reason is to avoid large sector exposures. The remaining equities are optimised to minimise tracking error v S&P 500.”

In the emerging markets mandate the starting point is global index MSCI EM. One of the key differences with this approach is that the MSCI is also using fossil fuel reserves as an input for carbon footprint. Initially companies with the largest fossil fuel reserves and emissions are excluded until 50 percent of the reserves and 25 per cent of the emissions compared with the standard index are excluded.

However, only a maximum of three companies per sector based on each parameter could be excluded. The reason for that is to limit the active sector exposures. The remaining companies are then optimized in order to maximize the reduction of carbon footprint subject to maintaining the tracking error below than 90 bps against the standard index.

There are also other constraints on active exposures to sectors and countries.

 

How well have these two low carbon mandates performed?

The carbon reduction in the US fund has been 55 per cent compared to the S&P which is above the target set by AP4, and the realized tracking error around 52 basis points.

Since inception the US low carbon fund has underperformed the S&P by 1 basis point.

“We have seen periods of low outperformance and low limited underperformance. The mandate has been running for 22 months and even though we think the period is too short for proper evaluation our assessment is that it looks promising,” he says.

“The EM low carbon fund has seen a carbon reduction of 85 per cent. The tracking error is 92 basis points. This methodology is clearly more aggressive than the other, but it is reasonable due to the nature of emerging markets. A tighter restriction on sector exposure than the standard index, that was implemented in May, that will hopefully lead to somewhat tighter tracking error. The EM fund has underperformed the standard index by 140 bps over 10 months. We think it is still too short to evaluate and we will continue to monitor it.”
Internal support key to success

Strong support from the board and management were critical to the success of the mandate design and implementation, Johansson says.

“To begin with we had very strong from the board and management all the way down the organisation. The project had high priority and it was therefore easy to implement. Another important factor was that the mandates fitted very well into our strategic portfolio with an investment horizon of three to fifteen years.”

He also identifies picking the right partners as crucial to success.

“Our partners have contributed greatly to our low carbon project and they worked hard to find good solutions both in terms of the indexes and the low carbon funds.”

AP4 plans to continue down the path of low-carbon mandates, and will invest in a Pacific region and Europe mandates by the end of this year.

Furthermore it is a target to measure the carbon exposure of the total equity exposure by the end of the year.

“We also expect investment in low carbon strategies will become more available at the same time as index providers are developing new standard indexes with carbon reduction,” he says. “In terms of policy it is difficult to predict if and when politicians will impose taxes or higher fees related to higher carbon emissions. However we expect the rhetoric will intensify.”

MSCI now has a set of Global Low Carbon Leaders Indexes, consisting of companies with significantly lower carbon exposures than the broader market.

This was developed with AP4 as well as the French reserve fund, FRR and Aumundi.

 

Mikael  Johansson was speaking at the Australian Superannuation Investors conference in Alice Springs.

The inability to scale hedge fund exposures and risks, has led many large investors, like CalPERS this week and ATP last year, to exit their hedge fund programs. Complexity continues to be a drain on the relevancy of hedge funds, but importantly cost is driving the agendas of these investors. As AQR’s Cliff Asness admits, the hedge fund industry needs to re-invent itself to remain relevant to investors.

CalPERS’ decision to eliminate its $4 billion, 24 manager, hedge fund program, as part of an ongoing effort to reduce complexity and costs, is consistent with many other very large asset owners which can’t scale such investments.

Last year the Danish fund, ATP, decided to re-unite its alpha and beta where formerly it had a number of risk-taking teams managing long-short equity, equity market neutral, and global macro.

One of the reasons for ATP’s move was that with a large number of small teams it was difficult to scale the size of the total risk in the alpha exposure. And there was risk of over-diversification. Because of the difficulties in scaling the efforts it was expensive to run.

Other large investors, such as the $65 billion AustralianSuper, do not have any hedge funds in their portfolio.

With both ATP and CalPERS the hedge fund programs in isolation were a success. But while ATP’s alpha team added $310 million, the impact of that was drowned out by the total fund size of $122 billion.

Similarly the $297 billion CalPERS has not based its decision to exit hedge funds on the performance of the program it began in April 2002.

But costs sure played a part. In its absolute return program last year (to June 30, 2013) CalPERS paid $60.7 million in management fees and $55 million in performance fees. That’s a total amount of $115.7 million on 2 per cent of the portfolio.

This compares with external management fees of $41.7 million and $46 million in external performance fees in equities (both domestic and global) which makes up about 50 per cent of the portfolio.

The total investment-related expenses, including all consultant, custody, legal and tax fees, at CalPERS came to $1.39 billion last year at a management expense ratio of 0.51 per cent.

In 2013 the board, and executive, went through an an extensive process to determine its investment beliefs, with the idea those beliefs would guide, among other things, investments, at the fund.

Two of those beliefs now include:

  • CalPERS will take risk only where we have a strong belief we will be rewarded for it
  • Costs matter and need to be effectively managed.

These beliefs helped guide the decision to exit hedge funds.

“We are always examining the portfolio to ensure that we are efficiently and cost-effectively achieving our risk-adjusted return goals,” said Ted Eliopoulos, CalPERS interim chief investment officer.

“Hedge funds are certainly a viable strategy for some, but at the end of the day, when judged against their complexity, cost, and the lack of ability to scale at CalPERS’ size, the ARS program is no longer warranted.”

Increasingly costs are the focus of large pension funds around the globe.

A survey of 19 of the world’s largest funds from CEM Benchmarking, which rates large funds on their costs, showed the funds on average spend 46.2 basis points on their external management compared to 8.1 basis points on internal investment capabilities.

One reason for the increasing focus on costs is that staff actually have some control over them, and can rely on them. In an environment that is made up of low-returns, low-contributions and high-promise-to-beneficiaries this is important.

With the news of CalPERS exit from hedge funds, AQR’s Cliff Asness has taken the opportunity to reiterate a couple of arguments he and his colleagues have been making for some time including whether hedge funds actually hedge, arguing that they are too correlated and that they are too expensive.

Because of this he’s not surprised that some have found the broad universe of hedge funds is not an attractive enough proposition.

Asness does believe that hedge funds, and active managers in general, do pursue some strategies that are very good – such as value investing, momentum investing, trend following, merger and convertible arbitrage; value, momentum, and carry applied to macro portfolios – but “more often than not, they charge too much for these straightforward, non-magic strategies and package them, again, with too much net long exposure”.

“We don’t dismiss that some fund managers may have real skill worthy of very high fees, and that some funds that aggressively pursue many of the strategies we list above, in diversified ways, also can justify high fees. But, all considered, we are not surprised that some have found that the broad universe of hedge funds, and thus likely any very large diversified portfolio of them, is not an attractive enough proposition.”

Hedge fund managers can argue all they like about whether they are performing, but as Asness importantly says the end investor is not getting enough of that, either in terms of a fair fee or enough diversification.

The news of CalPERS’ exit from hedge funds, hopefully, will be a wake-up call to managers to become more relevant to the needs of investors.

 

 

Low-volatility investing is becoming more popular. Many professional investors currently explicitly allocate a significant portion of their portfolio to low-volatility stocks. Robeco uses an enhanced approach to increase returns and reduce risk. Read the full article.