“In fact,” he adds, “they have very similar returns but they have very different benchmarks and therefore some funds did beat their benchmark because the benchmark had lower returns, not because the fund itself outperformed.”
A recent paper by Hermes Investment Management describes active share as “much talked about, often misunderstood and occasionally misused”. The paper argues a high active share portfolio picked by an unskilled manager is, in fact, more likely to significantly underperform.
The paper says: “Active share can only really be considered in the context of other factors, such as tracking error, to gauge how skilled a manager is and, therefore, how they might be expected to perform in the future.
“Without the presence of skill, a manager that looks like a lion based on their active share might actually manage like a lamb.”
Indeed, as GMO asset allocation specialist Catherine LeGraw believes, using active share as an exclusive selection criterion excludes highlyskilled managers who add performance through top-down asset allocation. She argues therefore, a portfolio should include managers with both high and low active share.
“There are powerful skill sets among managers that can lead to outperformance which tend to have a low active share; one of those is a manager with a good top-down allocation. For example, if going into 2008 you did not hold financials you would have had wonderful outperformance, but a very low active share.”
Majedie’s Harris also believes using active share in isolation is a “crude way” to screen funds. He claims a high active share really just means a wider range of possible outcomes – both up and downside – and says nothing about manager skill.
“A wide difference from the benchmark should not be used by active managers to justify high fees,” he says. “What you are really looking for is a more difficult task to select managers on a more rigorous and holistic manager research process where you are looking for those managers who have a structural advantage, for example due to limited capacity.”
Harris says one way to gauge a manager is by using the information ratio, a risk-adjusted measure which shows whether a manager has achieved a sufficiently high return versus passive but also per unit of active risk taken.
According to Aon Hewitt UK head of global manager research Philip True, investors also need to consider the universe in which the portfolio is invested. For example, UK equity managers generally tend to have a lower active share because of the greater concentration in the index, so 60% might be reasonable in the UK but low when viewed on a global scale.
He adds: “A high active share if not properly controlled in terms of risk, could mean a fund that is extremely invested in one sector or country will have the same active share as a manager that is diversified across a number of industries but holds stocks that are not correlated.”
Likewise, Inalytics chief executive Rick Di Mascio, believes active share is good for comparing the risk profile of portfolios through time, but only between managers within one category at a time.
“From a practical perspective active share is a good way to compare portfolios because there is no ambiguity in the number, whereas with tracking error you can get a different number depending on what window or methodology you use,” he says. “However, it is not useful in comparing, say, UK equities versus MSCI World because of the different concentration levels in the individual benchmarks.”
Of course, while useful for some metrics, active share is just one piece of the puzzle and investors should talk to their managers and get them to explain the philosophy and process in order to understand what they are investing in.
As AQR’s Frazzini says: “If you are using active share in the hope of outperformance then you are in for disappointment.”
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