Investors who are wed to passive management may have little interest in assessing which active managers are likely to outperform the benchmark. But for those who have done the research and see the value of an active approach, considering the Active Share measure as a valuable element of investment manager evaluation and fund analysis is key.
While the Active Share calculation was first introduced in 2006, it is not a financial term that’s widely known among advisors. Active Share was developed by Martijn Cremers and Antti Petijisto, then colleagues at the Yale School of Management, as a holdings-based measure used to determine how different a portfolio is from its benchmark. Benchmark differentiation is a requirement if a portfolio is expected to outperform, as a portfolio can’t both be the benchmark and beat the benchmark. Therefore, if advisors want a shot at selecting a fund that has a chance at beating the benchmark, focusing on funds with high Active Share is a completely rational response.
One reason Active Share isn’t widely recognized is that financial concepts can take decades to become broadly accepted and integrated. For example, Modern Portfolio Theory was introduced in the 1950s, but did not become broadly incorporated into advisor practices until the 1980s and 1990s.
Active Share falls into the continuum of benchmarking. The S&P 500 Index was created in 1957, and with increased computing power, asset management firms were capable of comparing portfolio performance with a benchmark by the late 1960s. However, benchmarking, especially style benchmarks, did not proliferate until the late 1980s and into the 1990s.
As portfolios became more closely scrutinized relative to a benchmark, portfolio managers become more aware of the benchmark and its composition. Managers found that by owning certain benchmark names, they could reduce the volatility of the portfolio relative to the benchmark. As periodic benchmark-relative performance reporting proliferated, managers recognized that underperforming in short-term periods led to potentially relationship-threatening client meetings. What good would it do to strive to deliver outstanding performance over five or ten years if the relationship would not survive that long?
In response, asset management firms began to impose restrictions (e.g., tracking error) to limit the expected portfolio return variation from the benchmark. Targeting “neutral” weights to the benchmark--that is, holding positions in proportions similar to the benchmark--became commonplace. This didn’t happen overnight. Over the course of the 1990s and 2000s, active managers, on average, shifted their portfolios toward the benchmarks they were being judged against. Some of this trend is likely related to the sheer asset growth in funds over the period, in addition to sensitivities about underperforming the benchmark during increasingly shorter periods of performance evaluation. And those elements are undoubtedly highly correlated. As funds reach significant asset size, the pain of losing assets is much greater than the pleasure derived from adding more assets.
As mentioned, Cremers and Petijisto developed the concept of Active Share and provided empirical evidence that tied relative performance to the degree of Active Share. The period analyzed by Cremers and Petijisto coincides with when managers were being forced to become benchmark aware. While Cremers and Petijisto had mutual fund data back to 1980, they chose 1990-2003 as their sample period, as almost all funds were very active in the 1980s. It wasn’t until 1990 and beyond that they saw a meaningful sample of funds with a modest Active Share (60 percent or less).
So the question for investors is whether the pendulum has swung too far for active management. As investing in passive benchmark proxies has become so inexpensive, investors should be questioning why they would pay a higher fee for active management despite the fact that the manager is actually closet indexing—meaning a large proportion of assets may be invested like the benchmark. Building portfolios in this fashion dooms such strategies to, at best, market-like behavior. The Active Share calculation shines a light on benchmark-hugging behavior and many asset management firms may be reluctant to publish Active Share statistics on their funds because of it. Some, in fact, have already begun to attempt to cast doubt on the concept. After all, many of the largest funds are now so asset-bloated, it may be difficult for them to reposition their portfolios to high Active Share.
That said, high Active Share merely establishes the right pond to fish for active managers. While perhaps less sporting, we believe it is much easier to land a trophy fish in a stocked pond than from a dry hole. Rigorous analysis and effort remains vital to identifying managers with a high potential to outperform from among the high Active Share options. Those investors who cannot or choose not to commit the necessary time and resources to such efforts may be best served by passive investing. But we believe the rewards to active management are potentially great for those investors who make the effort and have conviction in their selections.
Tim Paulin, CFA, is senior vice president of investment research and product management and Crit Thomas, CFA is a senior research analyst for Touchstone Investments, a mutual fund company that provides investors with access to institutional asset managers.