No two active fund managers are the same.
Friday, February 5th 2016, 10:20AM
by Harbour Asset Management
They differ in style, strategy and how much risk they take. These differences also lead to differential investment performance. To understand how, and whether, active managers are genuinely adding value, investors need to break fund returns into underlying market performance, and returns generated as a result of investment manager skill.
Active Share is a risk measure that may help investors evaluate fund managers.
Active managers attempt to add value by deviating from benchmark indices. Active Share looks at the degree to which the investment holdings in an actively managed portfolio differ from those of a market index or performance benchmark. Active Share helps investors to understand and compare how much idiosyncratic risk is in a fund.
A low Active Share indicates that a fund manager is closely following an index, while a high Active Share indicates the fund manager is choosing investments that differ from the exposures in the fund’s benchmark. For example, a New Zealand equities fund that owns the same holdings, in the same proportions, as its S&P/NZX50 index benchmark would have an Active Share of 0%. A New Zealand equities fund that holds stocks that are completely different from those in the index would have an active share of 100%.
Tracking error volatility, often simply called tracking error, is the traditional measure used to assess active management. Active Share and tracking error emphasise different aspects of active management. Tracking error measures the volatility of the fund that is not explained by movements in the fund’s benchmark index. Active Share quantifies active management at the holdings level and mostly measures manager risk in terms of stock selection. Tracking error is a returns based measure, and is a proxy for systematic factor risks such as tilts to sectors, industries, macro trends and market timing. By measuring active management using Active Share, investors can get a clearer understanding of what exactly a manager is doing to drive performance, rather than drawing conclusions from observed returns.
Some investors are looking to invest in funds that have a high Active Share content as markets become more volatile and to avoid high cost ‘closet indexing’ funds (managers who claim to be active, and charge active fees, but whose portfolios are very similar to the benchmark portfolio). Research by Martijn Cremers and Antti Petajisto of the Yale School of Management indicates that US fund managers with high Active Share outperform their benchmark indexes, both before and after expenses, and that Active Share significantly predicts fund performance. Their research also notes that US Funds with medium or low active share show indifferent performance to underperformance versus benchmark indexes over time, particularly after allowing for expenses.
Investing very differently from a benchmark can contribute to a fund performing better than its benchmark – or worse. Active Share does not show that holding deviations from benchmark index exposures will necessarily deliver better outcomes for investors. Funds with a high Active Share may have a greater dispersion of upside and downside risk. Active Share is not a complete measure of risk. Active Share does not account for portfolio construction, concentration of positions or diversification. For example, including small illiquid stocks or developing businesses in an equity fund will have a higher risk than a large defensive liquid stock with the same size “active” position.
Fund’s with a high tracking error don’t always have a high Active Share – they could be using factor tilts rather than stock selection to generate outcomes. Funds with high Active Share don’t always have high tracking errors – they may be holding idiosyncratic investments that have low non-systematic risk.
Figure 1 is a stylised comparison of different management approaches, and how they compare in terms of Active Share and tracking error. To provide a local example we have included the positioning of three different equity strategies managed by Harbour Asset Management.
Active Share is measured at a single point in time and needs to be calculated at the portfolio level regularly to be useful. It is difficult to calculate without a detailed data set and it can be cumbersome to create a series going back in time. Active Share may not provide a consistent comparison across different benchmarks and investment mandates.
But perhaps the key benefit in calculating Active Share for investors is that it exposes fund risk changes over time. Risk change over time, as measured by Active Share, could be part of a manager’s strategy. But risk change could indicate style drift (for example becoming more index aware), behavioural biases (for example risk aversion) or excessive risk taking incentives. Any of these changes may deliver investment performance that is very different from what the fund has generated in the past.
Investors can’t make decisions about manager skill or return potential using the Active Share measure alone. Investors considering investing in funds that purport to have a high Active Share component need to have a good understanding of the fund managers investment process and team. Importantly investors need to know whether the fund’s investment approach has been used consistently over a reasonable period of time and whether there has been any changes made to the fund’s investment process.
Investors also need to understand the funds risk profile relative to their own risk tolerance and relative to a reference benchmark (if they are using one). High Active Share funds should exhibit a degree of diversification and investment liquidity (ability to realise investments) that is consistent with investor objectives.
The development of the New Zealand capital market over the last few years gives fund managers a wider range of investment options from which to deliver Active Share. The introduction of new companies to the New Zealand market that may have return profiles that are very different from the broader market, and a broader range of fixed interest investment options, give fund managers a greater range of investments from which to create funds than was the case five years ago.
Active Share combined with tracking error and other measures can give investors a lot of information regarding risk and the style of a fund’s investment strategy. Active share is a useful metric to add to investors fund analysis tool kit especially as a comparison measure between funds over time. But to truly prove that managers with a high Active Share can persistently deliver better outcomes investors need to understand underlying investment processes and teams.
Tags: Harbour Asset Management
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The authors established that an Active Share of 60% or higher is generally considered active management. An Active Share of 20% to 60% is considered closet indexing, and an Active Share of less than 20% is considered passive (Exhibit 2).What percentage of active managers outperform? ›
Research by Morningstar found that about 40% of nearly 3,000 active funds outperformed their average passive peer over the 12 months through June. That success rate is worse than the 47% recorded in all of 2021, when markets were far less volatile.Do active managers outperform? ›
Active managers shine most in large-cap investments outside of the United States, according to Investment Metrics. Not all active managers struggle to beat market returns.Is high Active Share good? ›
Active Share is a measure of the percentage of stock holdings in a manager's portfolio that differs from the benchmark index. Managers with high Active Share have been found to outperform their benchmark indexes. The conclusion drawn by the study is that Active Share significantly predicts fund performance.Can Active Share be more than 100%? ›
For a strategy that does not short stocks and does not purchase stock on margin, active share will always be between 0% and 100%. In contrast, the active share of a hedge fund strategy can exceed 100% due to its use of leverage and short positions.Does Active Share matter? ›
Active share is a measure of the difference between a portfolio and a benchmark. It's an important concept for investors wishing to judge how fund managers' portfolios deviate from the index, and how that affects performance.Why do active managers underperform? ›
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What it means for investors. From an investor's perspective, it matters little whether managers are skilled or not, because fees eat up much of whatever skill and market-beating ability exists. Before costs and fees, active managers on average beat their benchmarks by 5 bp.What percentage of professional investors beat the market? ›
According to a 2020 report, over a 15-year period, nearly 90% of actively managed investment funds failed to beat the market. Portfolio managers are often Ivy League-educated investors who spend their entire workday attempting to outperform the stock market.What does Active Share indicate? ›
Active share is a measure of the difference between a portfolio's holdings and those of its benchmark, and the industry has increasingly used it as a proxy for how “actively” an investment manager is managing a portfolio.
Active share is a measure of how much a fund's holdings deviate from its benchmark index, and funds with the highest active share tend to have the best relative performance (in order to outperform, you must deviate from the benchmark).How is Active Share measure calculated? ›
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In general, actively managed funds have failed to survive and beat their benchmarks, especially over longer time horizons. Only one out of every four active funds topped the average of their passive rivals over the 10-year period ended June 2022.Does active management add value? ›
With no human portfolio manager to pay, costs are much lower than active management. While fees can affect returns, there's more to successful investing than cutting costs. Despite higher fees, active managers have the potential to add value to investor portfolios.Why is active management better than passive? ›
Among the benefits they see: Flexibility – because active managers, unlike passive ones, are not required to hold specific stocks or bonds. Hedging – the ability to use short sales, put options, and other strategies to insure against losses.
For example, if the benchmark return is 5% and the actual return is 8%, the active return would then be 3% (8% - 5% = 3%). If the same portfolio returned only 4%, it would have a negative active return of -1% (4% - 5% = -1%).What is a good tracking error? ›
Theoretically, an index fund should have a tracking error of zero relative to its benchmark. Enhanced index funds typically have tracking errors in the 1%-2% range. Most traditional active managers have tracking errors around 4%-7%.What is a good information coefficient? ›
Generally speaking, many portfolio managers would view a “good” IC as 0.05 and a “very good” IC as 0.10.What is Active Share and how can the measure help identify an investor as being active or passive? ›
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Understanding "smart beta"
Smart beta refers to an enhanced indexing strategy that seeks to exploit certain performance factors in an attempt to outperform a benchmark index. In this sense, smart beta differs fundamentally from a traditional passive indexing strategy.
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In any given year, most actively managed funds do not beat the market. In fact, studies show that very few actively managed funds provide stronger-than-benchmark returns over long periods of time, including those with impressive short term performance records.What is the benefit of actively managed funds? ›
Actively managed portfolios can offer greater flexibility to protect wealth throughout a market cycle, particularly during market downturns. The more passive the strategy, the more an investor is unnecessarily exposed to performance-crushing returns during a decline.What percentage of fund managers beat the S&P 500? ›
Across nine U.S. style categories, large-cap value managers performed the best over the 10-year horizon, with 32% of managers outperforming the benchmark, the S&P 500 Value.Is C fund better than s fund? ›
While the C-Fund invests in companies that are included in the S&P 500, the S-fund includes smaller companies than those that would be found in the C-fund. The “S” in S-fund stands for “small company stocks” but includes companies with market capitalizations that are considered medium-sized and large.What are three barriers to beating the market? ›
The Difficulty Of Investing In The Stock Market
There are 3 barriers that prevent an individual from investing in the stock market: fear, inequitable access, and insufficient funds.
Active share is a measure of the difference between a portfolio's holdings and those of its benchmark, and the industry has increasingly used it as a proxy for how “actively” an investment manager is managing a portfolio.What does Active Share measure? ›
Active share is a measure of the differentiation of the holdings of a portfolio from the holdings of its appropriate passive benchmark index.What is a good tracking error? ›
Theoretically, an index fund should have a tracking error of zero relative to its benchmark. Enhanced index funds typically have tracking errors in the 1%-2% range. Most traditional active managers have tracking errors around 4%-7%.What does most active stock mean? ›
The term most active refers to stocks whose shares have the highest trading volume on a stock exchange over a given period of time.How is Active Share measure calculated? ›
Active share is calculated by totaling the absolute value of the differences between the weight of each position in the portfolio and the weight of each holding in the benchmark and dividing by two.How are active returns calculated? ›
For example, if the benchmark return is 5% and the actual return is 8%, the active return would then be 3% (8% - 5% = 3%). If the same portfolio returned only 4%, it would have a negative active return of -1% (4% - 5% = -1%).What is a good information coefficient? ›
Generally speaking, many portfolio managers would view a “good” IC as 0.05 and a “very good” IC as 0.10.What are benchmark indices? ›
Understanding Benchmarks. Market benchmarks are indexes created to include multiple securities, assets, or other instruments to represent the performance of a stock, fund, or any other investment of the same type and composition. Benchmark indexes have been created across all types of asset classes.Does Active Share include cash? ›
All other security types such as cash, bond, warrants and derivatives are excluded.What is active risk CFA? ›
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Generally speaking, a Sharpe ratio between 1 and 2 is considered good. A ratio between 2 and 3 is very good, and any result higher than 3 is excellent.How do you evaluate a tracking error? ›
Given a sequence of returns for an investment or portfolio and its benchmark, tracking error is calculated as follows: Tracking Error = Standard Deviation of (P - B) Where P is portfolio return and B is benchmark return.What is the difference between active risk and tracking error? ›
1 Active return equals the difference in return between a portfolio and its benchmark. Tracking error, as active risk is more commonly called, measures the volatility of active returns. Both tracking error and absolute volatility are measured in units of standard deviation.Which shares fluctuate the most? ›
- Garden Silk Mills. ...
- Madhucon Projects Limited. ...
- KM Sugar Mills. ...
- 3i InfoTech Ltd. ...
- GVK Power & Infrastructures Ltd. ...
- Jubilant Industries. ...
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- Take Solutions Limited.
- Conduct a Self-Assessment.
- Arrange Sufficient Capital.
- Understand the Markets.
- Understand Securities.
- Set up a Trading Strategy.
- Integrate Strategy and Plan.
- Practice Money Management.
- Research Brokerage Charges.
The “volume” number is the total number of shares traded in that stock in one day. The “value” number is the total amount of money spent to buy all of the shares that were traded. “Volume turnover” expresses the day's volume relative to the total outstanding shares of the stock.