Opinions April 16, 2014

Active Share Helps Plan Sponsors Fulfill Fiduciary Responsibilities

April 16, 2014 (PLANSPONSOR.com) - Plan sponsors can use active share to help them stay on top of three important fiduciary duties.
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Active share helps investors identify just how active their equity managers’ portfolios really are, but it is also proving to be a versatile fiduciary risk management tool for plan sponsors by providing quantitative evidence in three areas of fiduciary oversight:

1. Ensuring plan assets are diversified.

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While equity managers with complementary investment philosophies and styles can help diversify aggregate plan assets, sometimes things get out of whack. One manager’s stock pick can cancel out the sale of the same security by another manager, for example. And a plan whose assets are allocated across a variety of investment mandates and styles can still produce an equity aggregate that looks like a closet index fund. Both are symptoms of overdiversification.

By analyzing the active share of the plan aggregate versus its benchmark, sponsors can see how active—or not—the aggregate really is and take corrective action.                               

2. Hire and monitor investment managers.

Active share analysis is best-known for uncovering closet indexers—something most plan sponsors want to avoid. But active share has many other useful applications.

It can shed light on an active manager’s investment process by evaluating what type of active decisions a manager makes, identify how sectors contribute to the process and even help determine whether a manager’s chosen benchmark is appropriate for their portfolio.

Holdings analysis: How a manager achieves active share

The chart below illustrates the types of active investment decisions a manager has made to contribute to its portfolio’s active share:

Assette byline 2 chart 1

By breaking out active share into the holdings categories shown on the right of the chart, you can see how a manager’s investment approach manifests in portfolio holdings versus the benchmark. In the above example, we see a portfolio where the largest active share is coming from avoiding certain securities held in the index. Virtually no active share is derived from underweighted positions in index securities.

This type of active share analysis can also be performed over various time series. The more consistent the pattern of active share by holdings types is over time, the more likely it is that the manager’s investment philosophy is being applied consistently.

Sector analysis: How sectors contribute to active share

The chart below illustrates the active share of each sector in the portfolio—demonstrating the extent to which each sector’s holdings vary from those in the index. The weights of each sector in the portfolio and the index, as well as the relative weight, are also displayed to provide context.

Assette byline 2 chart 2

This type of sector-level active share analysis treats each sector as its own portfolio and does not take into account the weight of the sector in the portfolio. Any sector not held in the portfolio, like Sectors 9 and 10, above, has an active share of 100%, since that sector is completely (i.e., 100%) different from the index sector.

Benchmark analysis: Is a portfolio true to its benchmark?

If a manager is true to its investment mandate, the portfolio’s active share should be relatively low versus its primary benchmark, since its holdings have the most overlap with that index. Conversely, the portfolio should have a high active share versus a different style benchmark, demonstrating little overlap in holdings. If the lowest active share aligns well with the benchmark, that’s good news. If not, it could be an indication that something is wrong. Perhaps it should be monitored against another benchmark or perhaps the portfolio is drifting away from its mandate. Either case should trigger questions from the plan sponsor.  

In the chart below, let’s assume the manager was hired to run an active small-cap growth portfolio using the Russell 2000 Growth Index as their primary benchmark—“index 1,” below. The plan sponsor runs an active share analysis of the portfolio versus the R2000 Growth, and also includes the Russell 2000, Russell Mid-Cap and Russell 2000 Value indices in their analysis.

Assette byline 2 chart 3

The portfolio’s active share versus the R2000 Growth is the lowest of the four at 93.31%. The portfolio’s active share also increases with each additional benchmark—from 93.62% vs. the R2000 to 99.05% vs. the R2000 Value. This is powerful evidence that a) the manager is staying true to its small-cap growth mandate and b) the portfolio has not drifted into small-cap, mid-cap or value territory.

3. Determine whether investment fees are reasonable.
Plan fiduciaries are charged with a responsibility to ensure plan investment fees are reasonable. Paying active management fees for a portfolio that is a closet index fund is a real and present danger for plan sponsors. Active share analysis helps fiduciaries quantify how “active” a portfolio is and make sure the fees they are paying are justified.

If a manager’s active share is less than 60% versus its benchmark, it is safe to say the portfolio is bordering on a closet index fund. The same is true of an aggregate portfolio. The prudent fiduciary will take corrective action to avoid paying active management fees for passive management.

This is the second article in a three-part series. Part One explained what active share is and how it is used as a portfolio monitoring tool.  Part Three will examine how active share can help identify style drift in active portfolios.          

Thusith Mahanama, CEO, Assette, provider of client communications solutions headquartered in Boston  

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.

Any opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.
Administration April 15, 2014

Corporate Pension Funds Far Healthier

April 15, 2014 (PLANSPONSOR.com) – Strong global equity market performance and higher liability discount rates worked wonders on the funded status of S&P 500 Index companies during 2013, says Wilshire Consulting.
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According to the “2014 Wilshire Consulting Report on Corporate Pension Funding Levels,”defined benefit (DB) pension plans sponsored by companies included in the Standard & Poor’s (S&P) 500 Index staged a remarkable improvement during 2013, with the aggregate funded ratio (assets divided by liabilities) increasing from 77.6% to 89.8% and the $371.2 billion funding shortfall shrinking to $153.9 billion by the start of this year.

This is the 14th corporate funding report issued by Wilshire Consulting, the institutional investment advisory and outsourced chief investment officer (OCIO) business unit of Wilshire Associates Inc.

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In other positive news, the percentage of corporate pension plans that were underfunded as of fiscal year-end 2013 fell to 80%, a substantial drop compared with fiscal year-end 2012, when 94% of the plans were underfunded, explains Russ Walker, vice president at Wilshire Associates and an author of the report. The median corporate funding ratio for fiscal 2013 was 89.3%—markedly better than the median funding ratio of 77.6% for the previous fiscal year.

Walker also notes that 61 of the 306 corporations in the study, or 19.9%, have pension assets that equal or exceed liabilities. In comparison, 18 of the 306 corporations’ defined benefit plans, or 5.9%, were fully funded or running a surplus at year-end 2012.

The total assets of the defined benefit plans analyzed for the study increased by $71.8 billion, or 5.6%, from $1.288 trillion to $1.359 trillion. At the same time, liabilities decreased $146 billion, or 8.8%, from $1.659 trillion to $1.513 trillion. Walker says interest rates used to discount current commitments to future benefits rose during 2013, contributing to the overall decrease in pension liabilities for the year. The median discount rate increased from 4.00% to 4.80%.

The defined benefit plans in Wilshire Consulting’s study yielded a median 11.1% rate of return for fiscal 2013. This strong performance combines with the 11.8% median plan return for 2012, the 3.6% median plan return for 2011, the 11.9% median plan return for 2010 and the 16.0% median plan return for 2009.

The combined pension expense for the S&P 500 Index companies in the study was $35.5 billion for 2013, down from $64.2 billion a year ago. Regular annual pension expense accruals from employee service and interest expense on existing liabilities totaled $96.2 billion in 2013, 2.3% lower than the $98.5 billion observed a year ago.

The S&P 500 Index companies in Wilshire’s study contributed $40.8 billion into their defined benefit plans in 2013, a decrease from the $61.1 billion contributed in 2012. Aggregate benefit payments from the S&P 500 corporate pension plans also increased 3.1% year over year. These plans’ benefit payments totaled $88.8 billion in 2013, compared with $86.2 billion during the previous year.

The distribution of pension liabilities and assets of S&P 500 Index companies is strongly concentrated among the largest plans, Walker explains. As of the end of fiscal year 2013, more than half of the total pension assets and liabilities were held by the 25 largest plans when ranked by both asset and liability size. Conversely, the smallest 100 plans when ranked by asset and liability size, made up just 2.6% and 2.7% of the total asset and liability pools, respectively.

According to Walker, to prepare the report, Wilshire collects data on U.S. pensions from 10-K filings for companies in the S&P 500 Index at year-end. All data for fiscal years 2013 and 2012 are based on S&P 500 Index constituents as of year-end 2013 and, therefore, may differ slightly from the list of companies represented in earlier years.

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