The quest for superior equity investment strategies is typically launched from the platforms of information advantage or unique insight. But there's another important potential source of excess returns: portfolio construction — that is, how effectively an investment manager's portfolio construction converts its collection of ideas into consistent outperformance.
In making that assessment, we consider such metrics as a portfolio's level of concentration, position sizing, explicit and implicit risk exposures, to name a few. But let's consider, instead, the impact that “active share” — or the lack thereof — can have on portfolio construction, and ultimately on portfolio returns.
What is active share? It's a measure of the degree to which a portfolio deviates from the benchmark. Unlike a purely passive strategy that attempts to replicate its underlying benchmark, portfolio managers that employ an active-share mindset intentionally attempt to have different exposures than the appropriate benchmark. “Active share” was coined by academics Antti Petajisto (NYU) and Martijn Cremers (University of Notre Dame) in a seminal 2006 study, “How Active is Your Fund Manager? A New Measure That Predicts Performance.”
In their paper, the authors offered a framework for analytically evaluating the impact a manager's portfolio construction decisions have on potential returns. But to understand active share it might be helpful to contrast it with a more common measure of how closely a portfolio follows an index: tracking error. Indeed, ex-post tracking error is the standard deviation of the return differential between the portfolio and the benchmark, calculated using historical returns over a very specific period.
Active share, on the other hand, is calculated based on weighted holdings (not returns) as of a specific point in time (and not over time). While tracking error statistics can be influenced — both up and down — by the changing magnitude of market returns over time, active share tends to be more stable from one period to the next.
To be sure, active share and tracking error are positively correlated: high tracking error typically corresponds to high active share. But, looking at tracking error alone can lead to some false conclusions. High active-share managers might have a low tracking error, and vice versa. With this in mind, we agree with Messrs. Petajisto and Cremers, who believe investors are best served by looking at active share and tracking error in concert with one another.
At the extremes, according to Messrs. Petajisto and Cremers, a portfolio manager can be a “stock picker” or a “factor bettor.” Stock pickers (designated as “high active share”) are more likely to own stocks that are not represented in the index, or they own stocks that are in the index but at a position weight that materially differs from the benchmark.
In contrast, factor bettors (or “low active share/high tracking error”) tend to focus on having specific factor exposures (style, size, sector and country, for example) that deviate from the benchmark while having individual position weights that are more in line with the index. Examples of a factor bettor might include a manager with a top-down approach or a quantitative strategy driven by desired factor exposures.
Portfolio managers with high active share have exhibited a persistent level of outperformance. Using data from the CRSP mutual fund database, Mr. Petajisto examined the returns of more than 1,100 equity mutual funds during the period 1990-2009. The data showed that the best relative results came from managers that displayed a high degree of active share and low tracking error — specifically, the group defined as “diversified stock pickers.” After adjusting for fees, factor bettors and closet indexers showed the worst performance.
At the same time, high active share does not reflect skill, nor does it ensure excess returns. But not incorporating active share into the evaluation process makes identifying an equity strategy that can deliver excess returns even more daunting. For example, if one assumes that 60% of a portfolio manager's strategy is explicitly or implicitly passively invested — leaving an active share, therefore, of 40% — the manager would need to earn a hefty 3.1% in excess returns on that remaining 40% of the portfolio in order to cover a 1.25% expense fee.
While we think it is important to have an appreciation for the effect active share can have on portfolio returns, we think it is also important to remember that academic research conducted over the past 30 years has yielded mixed results on the persistence of a manager's returns. In our view, the limited evidence of performance persistence does not, however, rule out the possibility of successful active management. It simply suggests truly skillful managers are hard to find. It also suggests looking at a manager's prior performance success is not necessarily a sound strategy in identifying prospective managers. High levels of active share, on the other hand, seem to have some correlation to excess returns.
The bottom line, in our view, is that portfolio construction considerations are an important and sometimes overlooked element in equity manager identification and selection — and active share is a dependable tool for evaluating one aspect of portfolio construction. Thus, it makes sense to consider assembling a collection of high active-share equity strategies that are also considered skillful, as evidenced by the ratings of the leading global equity manager researchers. The potential portfolio power of active share is worth a close and careful look.
Sean Chatburn is a senior associate in Mercer's Chicago office, working in the research division of Mercer's investments business. He may be reached at [email protected] Matt Reckamp is a Mercer principal based in St. Louis, who conducts manager research for U.S. equity strategies, and does client-related work. He may be reached at [email protected]