Investment Centre
Active Share – a powerful metric or a limited utility?
Key Points
- Active Share provides a straightforward measure of deviation from the benchmark. The higher the Active Share, the more a portfolio differs from its benchmark.
- Research indicates that there is no consistent link between Active Share and superior performance.
- Active Share does not account for risk and it is important to understand the full context within which the measure provides insights.
- Active Share alone is not enough to judge the quality of a portfolio. It should be combined with other metrics to evaluate the risk-adjusted performance of a portfolio.
In the realm of investment management, Active Share is a metric that gained prominence for its supposed ability to distinguish between true active management and closet indexing.
Active Share quantifies how much a portfolio’s percentage holdings deviate from the percentage holdings in the benchmark against which the Active Share is being measured. But does this metric truly offer the depth and breadth needed to evaluate active management? Or does it have limitations that investors should consider?
This article delves into the utility and constraints of Active Share measurement, offering a nuanced perspective on its application in modern portfolio management.
Understanding Active Share
Active Share is calculated by taking the sum of the absolute values of the differences in weight between each holding in the portfolio and its corresponding weight in the benchmark index, divided by two. It ranges from 0% for an index tracker using full replication, to 100% for a portfolio that holds no shares in the benchmark index.
Therefore, a high Active Share indicates a portfolio that is significantly different from the benchmark, suggesting active management. Conversely, a low Active Share suggests similarity to the benchmark, indicative of index tracking or closet indexing.
The appeal of Active Share
For investors and asset managers alike, Active Share holds several attractions:
1. Transparency and clarity
It provides a clear and straightforward measure of how an asset manager is deviating from the benchmark.
2. Promotion of genuine active management.
Highlighting portfolios with high Active Share encourages asset managers to genuinely seek unique investment opportunities rather than mirroring an index.
3. Potential for outperformance
Studies initially suggested that portfolios with a higher Active Share could outperform their benchmarks, especially in markets less saturated by professional investors.
4. Benchmark risk
For some investors, relative performance is more important than absolute performance, and Active Share will provide some insight into how different active return – the difference between the return of a portfolio and its benchmark – could be.
5. Fees for active management
Investors want to know that the fees they are paying for active management are deserved, and that the underlying managers are not simply hugging benchmarks (closet indexers).
Criticisms and limitations
Despite the attractions listed above, the utility of Active Share as the sole metric for portfolio evaluation does, however, face criticism.
1. Bigger Active Share …not better returns
Subsequent research has shown that a high Active Share does not consistently predict outperformance. Many funds with a high Active Share underperform their benchmarks.
2. Risk unaccounted for
Active Share does not account for risk. Two portfolios could have the same Active Share but vastly different risk profiles.
3. Not a guarantee of outperformance
There is a risk that investors might misunderstand Active Share as a guarantee of superior performance, and this could lead to inappropriate investment decisions.
4. Snapshot in time
Active Share is calculated at a specific point in time, so how it changes over time may need to be considered, in order to fully appreciate the benchmark risk
5. Skill and conviction
Investors also want to know that asset managers are not simply taking large active positions to look different to the benchmark, especially if they do not have high conviction in those positions.
Active Share in various markets
The relevance of Active Share also varies across different markets and sectors. Looking at active equity funds across global markets, some invest in narrow markets – such as South African equities – with highly concentrated benchmarks and only a short list of constituents. On the other hand, in global or regional categories indices hold a far longer list of names, with the largest stocks carrying lower weights than in narrowmarket indices. Hence, in more broadly diversified markets an active asset manager can deviate from the index much more easily, without excessively diverging in terms of style or market cap, than in a concentrated market.
Active Share vs active risk
Active Share, as mentioned, does not account for risk. However, active risk can be used in the tracking error measure to assess a portfolio’s risk relative to a benchmark/index, which comes in two variants:
The advantage of ex-post tracking risk over Active Share is that you do not need portfolio holdings or weights, which can sometimes be difficult to come by. All you need is the historical returns for the portfolio and the benchmark. Unfortunately, though, you do need the portfolio’s holdings for the ex-ante tracking risk and ideally, you would also like the covariance to be stable over time. The two measures are, however, highly correlated.
The future of Active Share
Looking forward, the role of Active Share and how it is applied as a metric remains a topic of debate, but it is unlikely that it will stop being used. It is essential for investors to use Active Share in conjunction with other metrics such as tracking risk, information ratio, and other return, risk, and risk-adjusted returns, to gain a holistic view of an asset manager’s performance and strategy.
Some investors may also not care about relative performance, in which case both Active Share and tracking risk will be of little use. In these cases, other measures may be more important – such as volatility, concentration risk, and liquidity risk.
Conclusion
Active Share is a valuable tool in the arsenal of metrics used to evaluate active management. However, its utility is not without limitations. Investors should appreciate both its strengths and its shortcomings. By understanding the full context within which Active Share provides insights, investors can make more informed decisions, balancing the search for active management with realistic expectations about performance and risk.
Using multiple and varied performance metrics is important to understand the portfolio from different dimensions, which provides a more holistic picture of the risk of the portfolio, both in absolute and in relative terms. The amount of risk an asset manager takes within a specific mandate should be proportional to their skill in managing that mandate and track record in adding alpha/outperformance