Dare to be Different:
Active Share
To achieve their goals, active fund managers must make choices that are different than their benchmarks’. But how different? And in what ways?
In recent years, active share has emerged as a useful tool to help understand how equity portfolio managers approach security selection, and the value of active strategies in general.
Beyond benchmarks
Actively managed equity strategies provide an important alternative to index strategies by making it possible to seek results tailored to specific objectives. Whether the goal is to heighten return or limit risk, the degree to which stock selection varies from the index is an important consideration.
That’s exactly what’s measured by active share. This statistic reflects the percent of a portfolio that differs from the benchmark index, based on both stock selection and relative weighting.1 The higher the active share, the more different the portfolio from its benchmark, and in principle, the greater the possible range of outcomes.
A matter of independence
Active share doesn’t predict success or failure. However, it does reflect a portfolio manager’s commitment to independence from a benchmark; as such, it has provided a reasonable proxy for the importance of stock selection in a portfolio’s investment process.2
That commitment is quite relevant, because while active management does not ensure gains or protect against market declines, investors pay a premium for active management. If an equity portfolio “hugs” a benchmark, with little deviation in both stock selection and weighting, investors are clearly justified in asking, “Am I getting what I paid for?”
Seeing active share in context
As with any single portfolio statistic, active share should be interpreted in the context of the manager’s process, position limits and risk philosophy. For that reason, the primary academic research on active share has focused on its significance in conjunction with tracking error3 and portfolio concentration, as expressed in five groups of mutual funds:
Based on historical performance (1990–2009) among over 1,100 active domestic all-equity portfolios, the three types with the lowest active share (“factor bets,” “moderately active” and “closet indexers”) averaged the worst excess return, while the two types with the highest active share (“stock pickers” and “concentrated”) produced the best risk-adjusted return for the period.2
Two important conclusions:
- First, higher active share appears to have been associated with higher risk-adjusted returns, even if it doesn’t imply higher returns for any particular fund.
- Second, the selection criteria and level of concentration may have played an important part as well as active share in determining a fund’s investment outcomes.
A stock pickers’ market?
Managers sometimes refer to a “stock picker’s market,” where correlations between overall asset classes are low to normal, and specific differences between individual companies are reflected in the relative movements of their stock prices. The analysis cited above further illustrates that active share’s association with higher returns was stronger when this is the case (in mathematical terms, when returns are more dispersed within an asset class).
Many believe that as the legacy of the financial crisis continues to recede, we are returning to a classic stock picker’s market. If true, managers with an independent approach to stock selection and a willingness to buck benchmarks — the key drivers of active share — may be well positioned to succeed.
1. As such, active share represents a more precise view of this issue than tracking error, which is calculated using actual returns, and thus reflects both systemic factors and stock selection.
2. Antii Petajisto, Active Share and Mutual Fund Performance, 1/15/13.
3. Tracking error is a commonly used measure of a portfolio’s deviation from a benchmark, specifically the standard deviation of the difference between the portfolio return and benchmark return over a series of time periods.
4. Alpha is a measure of performance vs. a benchmark, adjusted for the risk of the underlying asset class. An alpha of +1.0 means the portfolio has outperformed.
The views expressed are those of ClearBridge Investments, LLC and are current as of October 1, 2013 and are subject to change based on market and other conditions. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Any statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of the information cannot be guaranteed. The information provided is intended solely to describe the managers’ investment strategies and securities selection process, and does not have regard to the specific investment objectives, financial situation and particular needs of any specific person who may receive it. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase or sell such securities, and the information provided regarding such individual securities is not a sufficient basis upon which to make an investment decision. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies discussed should consult their financial professional. ClearBridge Investments and its employees are not in the business of providing tax or legal advice. These materials and any tax-related statements are not intended, or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties. Tax-related statements, if any, may have been written in connection with the “promoting or marketing” of the transactions or matters addressed by these materials, to the extent allowed by applicable law. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor. Past performance is no guarantee of future results.
Investment Risks
All investments involve risk, including possible loss of principal. Common stocks generally provide an opportunity for more capital appreciation than fixed-income investments but are subject to greater market fluctuations. Equity securities are subject to price fluctuation and possible loss of principal. The manager’s investment style may become out of favor and/or the manager’s selection process may prove incorrect; which may have a negative impact on portfolio performance. Diversification does not guarantee a profit or protect against a loss.
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