A metric that quantifies active management, ferrets out closet indexers

December 11, 2013

It has been seven years since Martijn Cremers and Antti Petajisto first introduced a new metric for determining the extent to which mutual fund managers were making active bets against their benchmark. They called the new tool active share, and went on to conclude that managers with an active share of 80% or higher tend to outperform their benchmarks—after fees—and they do so with persistence. Active share, they posited, is a useful tool for identifying managers that are likely to outperform. [i]

Since then, active share has been the subject of further research by Cremers, Petajisto and others. While some question the efficacy of active share as the be-all-and-end-all predictor of manager outperformance, there is one thing everyone seems to agree on: Active share is an excellent way to identify whether a manager is a closet indexer. As such, it has become a valuable piece of evidence for managers who want to demonstrate that they are taking active bets in their portfolio and to quantify the contribution their active approach is making to clients funds.

The chart below illustrates the overlap between one managers portfolio and the Russell 2000. In this case, 93.3% of the holdings differ from the benchmark. Such a high active share is powerful evidence that this manager is making active decisions.

What is active share?

The concept behind active share is simple: You cant beat the benchmark if your portfolio looks just like it. Active share identifies the extent to which a portfolios holdings diverge from those of the benchmark. Expressed as a percentage, it is calculated as the sum of the absolute value of the differences in the weight of each holding in a portfolio versus the weight of each holding in the benchmark index, divided by two. The formula reads:

What makes active share so useful is that it is calculated based on the actual holdings in the managers portfolio compared to the actual holdings in the benchmark index at a point in time. A high active share percentage demonstrates that the manager is taking more active bets against the benchmark. A low active share is a clue that the portfolio might be a closet index fund. Eighty percent and above is the accepted cutoff for what constitutes a high-active-share manager.

Active share vs. tracking error

In the past, most managers used tracking error volatility as the primary measure of active management. Tracking error measures the extent to which a managers returns differ from the benchmark return over the same time period. High tracking error is indicative of active management. Expressed as a standard deviation percentage, the tracking error of an index fund should be close to zero percent. An actively managed portfolio would have a higher tracking error.

But tracking error is based on a pattern of returns—a pattern that infers, but does not demonstrate, the level of active management. Active share, on the other hand, is based on actual holdings compared to benchmark holdings at the same point in time. It quantifies the active contribution in a way that gives investors a clear picture of where and how a manager is deriving active return.

This is not to say that active share should replace tracking error in a managers toolkit. Far from it. Even Martijn Cremers advocates using both in order to get a more complete picture of a managers active skill, saying, I would say, use active share within the fund-selection process, but as one of the many ingredients, including tracking error. [ii] But, for managers intent on demonstrating their active contribution to portfolio returns, active share may be their new best friend.

Benefits to managers

An increasing number of consultants are using active share in their analysis of individual managers and total client portfolios. And some managers are using their own active share numbers to illustrate their active contributions to existing and prospective clients. Says Terry Dennison, US director of consulting for Mercer Investment Consulting, Managers are now coming forward with their active-share statistics. Theyre not waiting for us to come to them. [iii]

In addition to making a stronger argument for active management, some institutional managers are expanding the utility of active share. Wellington Management has found active share useful as an internal metric during equity group peer reviews, as a tool to monitor portfolio risk, and as an effective means of evaluating multi-manager portfolios to avoid an aggregate closet index fund. [iv]

Conclusion

In the seven years since Cremers and Petajisto first introduced active share, the statistical tool has gained slow but steady acceptance among institutional managers, consultants and asset owners. It is a powerful evidence piece for managers who want to quantify their active contribution to their clients portfolios and distinguish themselves from closet indexers. Active share, used in tandem with traditional measures like tracking error and r-squared, adds depth and nuance to portfolio analytics by relying on a different set of observations (holdings vs. historic returns).

Finally, active share can serve a useful purpose as an internal tool to monitor the active contributions of individual manager portfolios, firm aggregate positions and multi-manager funds.

Are you using active share to quantify your portfolios active contribution? If not, active share may be your new best friend.

[i] Cremers, Martijn, and Petajisto, Antti. 2009. How active is your fund manager? A new measure that predicts performance.  ↵

[ii] Max, Sarah. 1.14.13. Is your fund manager active enough? www.online.barrons.com/article. ↵

[iv] Stahl, Kent; Gregg, Thomas; Simon, Tom. April 2011. Active Share: Predicting Alpha and Risk. ↵