Understanding active share: Dispelling misconceptions

Years after active share was “introduced” in 2006 and became the latest easy metric for identifying better managers, we recently saw the inevitable reversal in a recent FundFire article: Active Share Bubble has Burst.  Whether active share is the still latest fad or starting to wane in popularity, at Russell Investments, we continue to use active share in the same way we have for decades… since before active share was cool.

So, what is active share? Active share had been known internally and elsewhere as active money, active bets, or the “sum of overweight parts.” Ultimately, all these terms capture the same thing—to what extent an active manager is different from its benchmark, or what we will call “the market.”

However it’s defined, active share may be a useful tool for evaluating active managers if well understood. Unfortunately, the industry has promoted a couple key misconceptions. These include:

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

Not true. Here at Russell Investments, we typically prefer to use what we see as skilled active managers with high active share, rather than relying on the active share evaluation alone.  We do not believe this metric (or any single measure) is adequate for identifying those skilled active managers. In the absence of skill, high active share will likely lead to very different returns from the market, but those returns may be either inconsistent (sometimes above the market, sometimes below) or even worse, consistently below the market.

Moreover, screening on active share may exclude potentially attractive managers from consideration—including many quantitative managers—and may actually hurt total portfolio performance. 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

Again, not true. Active share needs to be interpreted differently for multi-manager funds. Even if there were a reliable positive relationship between active share and single manager excess returns, this relationship does not hold at the multi-manager level. Combining individual high active share managers will result in a multi-manager fund with lower active share plus the added benefits of diversification. The great thing about diversification is that it typically reduces benchmark-relative risk. The excess returns of high active share managers are not diversified in the same way that benchmark-relative risks are.

Here’s example: Consider a two-manager fund, where each manager has an active share of 95% and an excess return of 2.0%. The combined fund’s excess return will still be the average excess return of the individual managers or 2.0%.  However the combined fund’s active share will be lower than 95%. How can this be?  This is the power of diversification that we will explore in more detail over the next few posts coming from me and my colleague, Leola Ross.

The bottom line

Active share has grown in popularity over the last few years. Russell has been using this metric to evaluate managers for decades.  While it can be a useful measure, we do not believe it can predict positive excess returns and counsel against relying on it exclusively. The industry is now starting to understand why this is true.

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.

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