In an ideal world, no fund manager would claim to be running an active fund while secretly sticking close to benchmark weightings. However, it happens. Fund managers may fear for their jobs, they may be tied by their mandate or they may not be very good at picking stocks. This means that fund selectors need to find ways to ensure that the active managers they employ are genuinely active.
Private wealth manager SCM Private, run by Gina and Alan Miller, has brought the matter to the fore. It launched a campaign in February of this year claiming that as many as one in three actively-managed UK equity funds were in fact ‘closet trackers’ charging more than tracker funds but holding similar weightings to the index. The group claimed that this this left investors out of pocket to the tune of £803m in 2014. It called on active managers to reveal their ‘active share’, showing the extent to which they deviate from the index. Active share is ranked on a scale of 1 to 100, where 100 means holding none of the same stocks as the index.
The concept of ‘active share’ was established in 2009 in a paper by Antti Petajisto. It describes the share of portfolio holdings that differ from the benchmark index. The paper combined active share with tracking error volatility to measure active management.
It found that the extent to which a fund manager was ‘active’ was predictive of returns, with funds with high active share significantly outperforming their benchmark indexes both before and after expenses. It found that they exhibited strong performance persistence even after controlling for momentum. Non-index funds with the lowest active share underperform, it found.
This was supported by research from Simon Evan-Cook, senior investment manager at Premier Multi-Asset Funds, which showed that “highly active” UK equity managers, defined as those having an active share of at least 80, have beaten the FTSE All-Share index over one, three, five and 10 years, and by a significant margin.
This has been used both as a means to defend and attack active management. While Evan-Cook argued that it showed fund managers could outperform providing they were sufficiently active, others have taken it as an indictment of the whole industry.
The Centre for Policy Studies, for example, has long been sceptical of much active management, with its pensions expert Michael Johnson calling it ‘a web of meaningless terminology, pseudoscience and sales patter.
“For too long, active managers have been allowed to shelter behind their standard disclaimer concerning the long-term nature of investing. But the long term never arrives. It merely shuffles forward; there is never a day of reckoning,” he says.
“In practice, some so-called active managers are actually ’closet trackers’. Once their high costs are deducted, the outcome of sub-index performance is no surprise. To misquote Sir Winston Churchill: never is so much being taken by so few from so many, and for so little in return.”
Against this backdrop, a number of fund managers have committed to revealing their active share. Neptune, Threadneedle and Baillie Gifford, for example, have all said they will now show active share on their factsheets. At the time, Robin Geffen, chief executive at Neptune, told the Financial Times: “Somebody has to be brave and go first and show their hand. I think this will be the single biggest industry change that happens this year. It is the beginning of a sea change.
”There are lots of people who make a lot of noise about [being genuinely active] but have not published the numbers. We would like to see everybody doing it.”
Baillie Gifford showed active share of between 69 per cent (for the Baillie Gifford Greater China Fund) and 99 per cent (for the Baillie Gifford Global Discovery Fund and Edinburgh Worldwide Investment Trust).
Marketing director James Budden says: “We recognise the need for investors to be able to identify an actively managed fund from in-and-amongst the shoal of ‘closet tracker’ funds. To have any chance of outperformance you must be different from the index. Anything over 60 per cent suggests you are on the right track.
“By publishing the ‘active share’ figure we are providing a transparent indication for investors. We are giving investors the ability to determine whether a fund is being managed on a truly active basis or not.”
However, other fund groups have questioned the validity of active share as a measure. Although it now publishes active share data, Rob Harris, chief executive officer Majedie, has highlighted the limitations of active share as a measure of how ‘active’ a fund manager is in their approach.
He says: “There is clearly an increasing groundswell of opinion that a high active share in itself represents investment nirvana – and is a flawless means of sorting out the wheat from the chaff. It is of course human nature to look for a short cut where the alternative, in this case doing the hard work necessary to uncover structurally advantaged active managers, is much less convenient. Indeed, the data from our funds explode the myth that a high active share is a simple gold standard to which fund managers should aspire. “
Harris points out that it is possible to generate a return significantly different to that of the index despite having a relatively low active share.
The Majedie UK Equity Fund was launched in March 2003 and from then until 31 December 2014 the fund returned 13.9 per cent per annum net of fees, compared to the FTSE All-Share index return of 9.6 per cent. Over three years the fund returned 15.6 per cent per annum net of fees, compared to the index’s 11.1 per cent. However, three years ago the fund’s active share was only 56.6 per cent. ”According to current received wisdom, with an active share at or below 60 per cent, this fund is not being actively managed,” says Harris.
The first problem with active share as a measure is that it is relatively easy to get a high active share simply by investing in smaller companies. The significant outperformance of small and mid cap companies over the past 10 years means that any fund overweight in this part of the market would have outperformed and would also have a high active share, but this tailwind might not persist indefinitely. Investors will be looking for their managers to demonstrate more skill than simply a structural overweight to small and mid caps.
Stephen Peters, analyst at Charles Stanley, says correlation is not causation: “Funds with a high active share may have outperformed because they do not have the right benchmark, for example. UK funds are generally benchmarked against the FTSE All Shar and 85 per cent of the FTSE All Share is in large cap FTSE 100 companies. If a manager buys lots of smaller and mid cap shares, they will have a high active share before they have even started. They may also generate outperformance, but it is not the right benchmark.” The real test of manager skill would be if they were outperforming a smaller cap benchmark.
Harris says that funds benchmarked against domestic equity market indices, which are inevitably more concentrated than their broader global cousins, may throw up somewhat rogue active share results. Majedie’s three newer funds, which have Global or US equity market benchmarks, have active shares of between 85 per cent and 95 per cent.
Peters agrees: “It is easier to have a high active share in global funds than in UK funds. It is more difficult to have a high active share if you are invested in larger cap. Ultimately, style may be a more important predictor of returns.”
There is also the cyclicality problem. Sometimes it will be right to invest in larger companies, and therefore have a lower active share. As Harris says: “Active share should be largely ignored during those periods in the economic or market cycle when an index’s largest constituents are attractively cheap.”
Hugh Yarrow, manager of the Evenlode Income fund, says managers need to be sure that active share does not become the dominant driver of investment choices.
“Active share is an output of the process. It certainly shouldn’t be an input. The most important determinant of returns is investment process. Active share will vary over time. It is an important idea, but it should be a result of what is being done. Sometimes it will be in the best interest of investors to have a lower active share. There might be more value in certain larger companies, for example,” he says.
He points out that his active share is currently 78 per cent, but has been higher when the portfolio had a greater weight in smaller companies. At the moment, active share is lower because the managers see more value in larger companies. He also says that it is possible to increase the active share of a portfolio through a few significant bets. A 4 per cent non-benchmark holding, for example, would up the active share by 4 per cent even if larger holdings looked relatively similar.
More recent research suggests that a high active share may not even be desirable in certain markets. Analysis by Nomura also calls into question the reliability of active share as an indicator of good performance. It analysed the US market, generally seen as more efficient than other global markets, going back to 2004 and concluded ”that active share has not been a reliable indicator of fund managers’ success, at least not over the past decade, and may be overrated as an investment tool”.
The Nomura research called active management into question. It found that those funds with a low tracking error compared to the S&P 500 – “diversified stock pickers” – beat those with a high tracking error – “concentrated stock pickers”. The 20 per cent of funds with the lowest active share and tracking error were deemed to be closet trackers and they outperformed the diversified stock pickers in seven of the 11 years from 2004 to 2014, and beat the concentrated stock pickers eight times.
Part of the problem, Nomura concluded, was that managers with a high active share may have more scope to beat the index than closet trackers, but they also had more scope to make mistakes.
Fund selectors are sceptical of the utility of active share. Gary Potter, joint head of multi-manager at BMO Global Asset Management, says: “We do not use it. We believe it is simply a by-product of active management, not a driver.”
So if active share is, at best, an unreliable guide to both the relative activeness of fund manager, and – in certain markets – to the likely outperformance, what other measures may be employed?
Eoin Murray, head of the investment office at asset manager Hermes, points out that there are a number of ways in which a manager can vary their portfolio holdings relative to the benchmark such as simply overweighting or underweighting positions relative to their benchmark weights. They can also hold “off-benchmark weights, which can be separated into positions that maintain the structure of factor bets relative to the benchmark of the portfolio as a whole, versus those that introduce additional factor exposures (cash would be a simple example of this latter effect)”.
Therefore, the relative success of individual overweight and underweight positions offers some insight into where the strengths of a particular manager lie. Murray says: “Do their best ideas manifest as ‘long’ or ‘short’ positions relative to the benchmark? However, a very broad benchmark might impede realistic research coverage, and potentially increase the number of indirect underweights. Similarly, shorting restrictions might impact the asymmetry between the number of overweight and underweight positions in a portfolio.
“We can split portfolio activity into different tasks – finding winning stocks, selling losing securities and knowing when to recycle or hold on to a particular name. In terms of the first skill, a percentage hit rate will provide an indication regarding the subsequent performance of a manager’s buying decisions. Values greater than 50 per cent illustrate that more than half of a manager’s buying decisions were correct – consistency is also pleasing, and by looking at different time horizons, one can begin to discern how sustainable a particular manager’s strategy is over the long term.”
He suggests that fund selectors might choose, for example, to examine the time series of the manager’s average return post trade for a particular time horizon, such as, 12 months. This would demonstrate a degree of persistency in their ability to find winners within a particular timeframe, and a fund selector can check whether the numbers support that claim.
Equally, a manager’s skill in selling should be examined. Murray says: “The ability to know when to sell a particular position is the second skill that we can seek evidence of.
“This time, we are studying the percentage of a manager’s selling decisions that subsequently proved correct as the stocks went on to underperform – as before, values greater than 50 per cent are desirable as these indicate that more than half of the selling decisions were good ones.”
He also points out that looking at the variance in active share might be important. This shows whether a manager is varying active share to suit different market conditions, rather than it remaining static at all times.
Harris believes that fund selectors should also be looking at information ratio. It says: “This shows the fund return net of fees, divided by active risk over, say, rolling three-year periods. This should illustrate whether active managers have achieved a sufficiently high return versus passive, net of fees and also per unit of active risk taken.”
There is also the issue of size. This will feed into whether a fund manager is in a position to be genuinely active. If a fund is too big, it cannot invest outside the larger stocks in a stockmarket without risking its liquidity position. Therefore smaller funds may also tend to have a structurally higher active share.
It is difficult to argue with the conclusion of Kevin Murphy, co-head of Schroder’s Global Value Equity team: “A high active share will only be of any real benefit to investors if it is allied to the skills of a good stock-picking manager. Clearly anyone could create a very high active share from a portfolio of imaginatively random companies but that hardly guarantees clients will be queuing up to thank them five or 10 years down the line.”
Active share is a crude tool. It may have been correlated with higher returns in the past, but it is difficult to disaggregate how much this is simply a factor of small and mid-cap outperformance. It is an output of good active performance rather than being predictive and it is only useful in combination with other metrics.