Interpreting active share

Recently, the number of questions and interest in active share1 have picked up–whether it’s mentions in the media or questions from the advisors we work with. While this “new” fad has gotten a lot of attention and investors believe it could be the silver bullet for picking the best managers, we aren’t as impressed. Many concepts are popular to folks who haven’t heard of them before, but at Russell we’ve been using active share since before it was cool. We have tracked the active share of managers and multi-manager funds since the 1980s and it has been part of the broader investment industry's toolkit for decades. Active share had been known internally and elsewhere as active money, active bets, or the “sum of overweight parts." Also, the popular metric often called "commonality" actually just equals (1 - active share). Whatever we call it, active share can be a valuable addition to institutional investors’ analysis as they evaluate active managers and combine them to build multi-manager funds. However, there are a couple key misconceptions.

Misconception #1: High active share leads to higher returns compared to a benchmark

Russell typically prefers to use active managers with high active share. We agree with much of the academic and practitioner literature that, in general, these managers have the potential for higher levels of outperformance (relative to their benchmark) than their less active peers. Importantly, however, we do not believe this metric (or any single measure, for that matter) is adequate for identifying active managers that will outperform. Without skill, high active share can simply lead to uncompensated active risk. In our experience, many high active share managers perform poorly and vice versa. There are many notable lower active share managers that have generated strong long term returns greater than their benchmark ("excess returns"). Many quantitative managers fall into this category. Screening on a single variable, like active share, would exclude these potentially attractive managers from consideration. Active share is a complement to our in-depth manager research process, not a substitute for it.

Misconception #2: Multi-manager funds are closet indexers given their low active share

Active share needs to be interpreted differently for multi-manager structures. Even if there were a reliable positive relationship between active share and single manager excess returns, this relationship breaks down at the multi-manager level. This is a fact of how diversification works–something that is often forgotten by proponents of active share when they evaluate multi-manager funds. Combining individual managers with high active shares will result in a multi-manager fund with lower active share. However, the returns of the multi-manager fund will always be a weighted average of the underlying manager excess returns. This may sound familiar to many readers–returns are additive, but risks (and active share is a simple measure of risk) are not. This is a mathematical fact, not an opinion–the excess returns of high active share managers cannot be "diversified away." A simple example is enough to demonstrate this. Consider a 2 manager fund, where each manager has an active share of 95% and an excess return of 2.0%. The combined fund will (unless the managers have identical portfolios) have an active share lower than 95%. The lower the overlap between the managers, the lower the total fund's active share will be. But, the 2 manager fund's excess return will still be exactly 2.0% (the average of the excess return of the individual managers). The 2 manager portfolio has the same return with lower active risk than either manager alone.  In this case, lower active share is a demonstration of diversification rather than an indication of lower excess return or closet indexing. A more detailed example shows how this works in the real world: microcap in a small cap fund. Consider a hypothetical small cap fund that adds microcap managers to the offering. Microcap provides access to a highly inefficient, capacity-constrained asset class segment with attractive active management opportunities (due to greater market inefficiencies further down the cap spectrum). Theoretically, adding exposure to microcap has the potential to improve expected returns.2 Because mathematically the fund’s expected excess return must be a weighted average of the underlying managers, and because Russell believes microcap managers can have higher expected excess returns, the microcap sleeve has the potential to increase the fund’s return. However, it also reduces the overall active share. This example highlights that higher active share for a multi-manager fund is not necessarily a good thing while actually lower active share can be. The portfolio with microcap is potentially superior–it has higher expected returns even though it has lower active share (and lower expected tracking error). In U.S. large cap, we see many strategists hiring several funds to cover this space–a growth manager, a value manager, a quant manager, market orient manager, etc. While many may evaluate the active share of each underlying fund, I often wonder how many look at the active share across the entire combination? My colleague in our Institutional business, Bob Collie, has written about this topic on Russell’s Fiduciary Matters Blog. Bob states that “active share is a useful measure in researching money managers, but it’s never been the cause of good performance and we need to be wary of assuming that it will have the same information value in the future as it has in the past.” I encourage you to read Bob’s take.

The bottom line

Active share has become a more popular measure in the last few years, and unfortunately many in the industry ascribe it almost magical powers. Russell has been using this metric to evaluate managers for many decades, and while it can be a useful measure, we do not believe it can predict positive excess returns. We are encouraged by the industry's broader adoption of the metric, but counsel against relying on it exclusively. While we continue to include active share in our investment toolkit, we believe that a comprehensive manager research process that incorporates both quantitative and qualitative components is a more reliable way to identify true skill.
1 Active share, also known as active money and/or commonality, is defined as the proportion of stock holdings in a mutual fund's composition that is different from the composition found in its benchmark. The greater the difference between the asset composition of the fund and its benchmark, the greater the active share. For example, a mutual fund with an active-share percentage of 75% indicates that 75% of its assets differ from its benchmark, while the remaining 25% mirror the benchmark. 2 Microcap stocks may be newly formed with more limited track records and less publicly available information which can lead to greater risks.