By Bernd Meyer and Ulrich Urbahn
‘Active share’ measures how far a portfolio deviates from its benchmark allocation – based on portfolio holdings data. Combined with tracking error it helps to identify truly active portfolio managers and to distinguish different types of active asset management. Investors also make increasing use of active share to discern managers with outperformance potential – backed by academic literature which has shown that funds with a high active share were more likely to outperform after costs.
In 1980, almost 60% of US mutual funds were considered very active with an active share of 80% or higher. Until the end of 2009, the share of very active funds declined steadily to roughly 20%. The decline in active share funds seems to coincide with the increase of underperforming active funds over these years.
Traditionally, a portfolio’s degree of active management has been described by tracking error, the volatility of the fund’s excess return. For example, a benchmark containing 10 sectors and five stocks in each – a manager could invest in one stock in each sector, while keeping the same sector weights as the benchmark meaning the portfolio may exhibit a relatively low tracking error due to similar sector positions even though the manager’s stock weightings deviate sharply from the benchmark.
The other way round is also possible: without excessive deviations from benchmark holdings a large tracking error can be generated through significant active sector positions. Generally, an active manager can use two different approaches to deviate from the benchmark: factor timing and stock selection.
Pure index funds exhibit a zero or very low tracking error as well as a minor active share. Closet indexers do not engage much in any type of active management but have more degrees of freedom. Fund managers concentrating on factor bets generate large volatility with respect to the index but do not deviate significantly from the benchmark in the single holdings. For diversified stock pickers the opposite is true. However, the most active fund manager is a concentrated stock picker as he combines very active stock selection with exposure to systematic risk.
Closet indexers appear to be a problem: while they usually stay close to the benchmark, they often charge management fees similar to those of truly active managers. Given that concentrated stock pickers are the most active management type they should charge the highest fees in line with the higher required management skills.
Concentrated stock pickers charge on average 1.60% fees, while funds which concentrate on factor bets have an expense ratio of 1.34% and closet indexers demand 1.05% fees. Moreover, closet indexers are nevertheless relatively expensive. Firstly, passive index funds such as ETFs usually charge less than 30 basis points per annum. Secondly, closet indexers are more expensive per unit of active share or tracking error than other actively managed funds.
One of active share’s benefits is to identify expensive closet indexers. Active share identifies truly active managers and is a more persistent indicator than other statistics. Active share can also provide a valuable insight into a portfolio’s propensity to beat its benchmark. Funds with the highest active share beat their benchmarks by 1.3% per year net of fees and expenses, while closet indexers underperformed before and after costs. A Morningstar study came to similar results.
Nevertheless, there are also some drags with regard to active share. For example, a fund manager’s benchmark may differ from that of the investor, i.e. the active share measure can be misleading if the benchmarks are substantially different. Furthermore, the active share measure depends on the benchmark’s structure, e.g. for small cap indices the enormous number of securities generally leads to ‘artificially’ high active share figures. Active share should therefore be compared only within the same security universe. Studies have further shown that active share declines with the rise in assets under management.
Last but not least, the latest holding data for funds are not easily available which might make it difficult to calculate the active share; furthermore there can be licence issues with regard to the benchmark holding data. We are also of the belief that analysts’ earnings expectations are too pessimistic at this stage of the economic recovery. This increases the chance of positive surprises that could possibly boost European equity markets in the future.
Bernd Meyer is head of cross asset strategy and Ulrich Urbahn is senior cross asset strategist at Commerzbank
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