Paying Active Fees for Passive Management?

Identifying truly active managers is a constant challenge for plan sponsors. The market downturn of 2007-2008 sent most managers running for the cover of their benchmarks. Many never left—they still tout an active approach, but never stray too far from the index.

So how can plan sponsors, charged with a duty to ensure plan assets are diversified and investment fees are justified, ferret out these closet indexers? Enter a very handy tool called “active share.”

Developed by finance professors Martijn Cremers and Antti Petajisto to analyze active bets by mutual fund managers, active share’s ability to predict outperforming managers is the subject of ongoing debate. But there is one thing everyone seems to agree on: Active share is an excellent way to identify whether a manager is a closet indexer.

What is active share?

The idea behind active share is simple: To beat the benchmark, a portfolio must be different from the benchmark. In order to be different, a manager must make active judgments, typically in one of four ways:

    1. Holding securities that are not in the index.

    2. Holding securities in the index, but overweighting the position.

    3. Holding securities in the index, but underweighting the position.

    4. Not holding securities that are in the index.

Active share identifies the extent to which a portfolio's holdings differ from those of the benchmark. It is based on a 0% to 100% scale. Index funds have an active share of less than 20%, meaning 80% of the portfolio overlaps with its benchmark. Portfolios with an active share of 80% or more are considered quite active—only 20% of their portfolio’s holdings mirror those in the benchmark.

Active share and tracking error

Until active share emerged, tracking error volatility was the primary measure of active management. This is not to say that active share should replace tracking error in a plan sponsor’s toolkit—far from it.  Active share complements tracking error by providing a different perspective on the portfolio. Dr. Cremers advocates using both metrics in order to get a more complete picture of a manager's active skill.  Here’s why.

Tracking error is based on the pattern of portfolio returns compared to the benchmark returns over the same time period. That pattern infers, but does not describe, the level of active management. Expressed as a standard deviation percentage, an index fund’s tracking error should be close to zero percent. The more active a portfolio is, the higher its tracking error should be.

Active share, on the other hand, is based on portfolio holdings compared to benchmark holdings at the same point in time. It quantifies the manager’s active contribution in a way that gives investors a clear picture of where and how a manager is deriving active return. Because it uses a different set of data than tracking error, active share can diversify and enrich your analysis of active management.

How much active share do you need?

What percentage of active share should you look for in your managers’ portfolio? According to Dr. Cremers, the number varies by manager style. In a recent Wall Street Journal article, he said an active share of at least 60% is good. Large-cap managers should be in the 70%-plus range; midcap managers in the 85%-plus range; and small-cap managers should have an active share in excess of 90%.

The pie chart below illustrates a portfolio with 6.69% of its holdings overlapping those of the benchmark. That leaves 93.31% of the portfolio holdings that differ from the benchmark, an indication that very active judgments are being made.  With an active share of 93.31%, this manager is no closet indexer!

Conclusion

Active share is a valuable statistic for plan sponsors who want to separate closet indexers from active managers. If your managers and/or consultants are not providing you with active share data, they should be able to include it as part of their standard performance reporting package.

Thusith Mahanama, CEO, Assette  

This article is the first in a three-part series. Our next article will explore different ways active share can help plan sponsors exercise specific fiduciary duties.