A Closer Look at Active Share

June 4, 2018

Research suggests that there is no correlation between a manager’s active share and future performance.

  • Active share measures a portfolio’s differentiation from its benchmark index.
  • There is a perception that higher levels of active share are associated with subsequent outperformance.
  • Research suggests that there is no correlation between a manager’s active share and future performance.

Active Share—A Quick Overview

The concept of active share was introduced by two Yale finance professors in a 2006 paper. Active share measures the percentage of a portfolio that is different from the portfolio’s benchmark index. An active share of 0% indicates a portfolio is identical to its benchmark and has no active biases. A value of 100% means the portfolio is completely active, holding none of the securities in the benchmark index. Because active managers must deviate to some degree from a benchmark in order to outperform it, higher active share scores typically reflect more aggressive active management.

Active: Yes. Predictive of Performance? No

In their original paper, the professors claimed that higher levels of active share in a given mutual fund were associated with subsequent outperformance. Follow-up research contradicts that view, showing that there is no correlation between a manager’s active share and future outperformance. In fact, active share was found to strongly correlate with the type of benchmark, but had no predictive ability for returns within a specific benchmark. While active share can help individuals compare funds within a given benchmark or asset class, the recent studies conclude there is little, if any, predictive ability of future returns after controlling for the benchmark type.

Active Share—Some Additional Caveats

Active share can be acquired in different ways. For example, a portfolio manager could hold only cash, or hold many securities that are not in the benchmark index (sometimes referred to as off-benchmark investing), or hold benchmark securities in different weights than the benchmark does. There are obvious problems with holding all of a fund’s assets in cash; for example, because of fund expenses and the low returns available on cash and other short-term investments, it would be like putting your money into a savings account with a negative rate of interest.

The issues with holding many securities that are not in a manager’s benchmark are more technical, but the most important one is that a manager could be using an inappropriate benchmark. For example, a manager that invests largely in Treasury bonds should not be employing a stock-market index like the S&P 500 as its benchmark.

Active Share—Some Misconceptions

Active share has been misunderstood in some quarters. For example, instead of viewing it as a direct measure of differentiation from a benchmark, it is sometimes associated with portfolio concentration, meaning a portfolio with most or all of its capital in a small number of holdings. While a concentrated portfolio will typically have high active share, concentration is not the only way to get there.

This misunderstanding has led some to question whether multi-manager portfolios can be too diversified. Could a multi-manager approach result in too many managers holding too many stocks, such that active positions are watered down or even canceled out, lowering the odds of outperformance? Although this question misunderstands and incorrectly applies the concept of active share, it is worth examining.

Active Share and Skill in a Multi-Manager Context

To do so, we used computer simulations employing various assumptions about market behavior, manager-skill levels and number of managers in a portfolio. We found that in our hypothetical simulations, active share declined marginally as managers were added to a fund, and the variation between fund and index returns declined. However, there was not a clear relationship between active share and outperformance, and the strongest determinant of outperformance by far was manager skill. Our simulations led us to the conclusion that, within reasonable limits, as long as we can identify managers with a given level of investment-selection skill, adding them to a fund should improve overall performance.

Of course, it’s important to understand that every model, including the one used in our simulations, is an imperfect reflection of the real world. We did not incorporate an exhaustive array of variables or assumptions. However, given the size of a typical stock-market index and the size of a typical active manager’s portfolio, the math argues against the idea that multiple managers will cancel out most of the active bets in a portfolio. We do not believe that additional assumptions would change the observed relationships between active share, volatility and performance in our simulation.

Our View

While off-benchmark investing does have a place in active investing, we prefer our managers to differentiate themselves by holding securities within a benchmark at different weights than the benchmark.

While active share is a relatively new concept, the selection of investment managers has long included assessments of how a portfolio differs from its benchmark. Active share certainly has a place in our manager-evaluation toolbox, but its basic intent is not new.

It’s also important to point out that at its most basic, active share is just another way to measure and identify sources of differentiation, something that SEI’s investment manager-selection process has been doing for a long time. We believe that manager skill, not active share, is the critical metric for a multi-managed portfolio. Our multi-manager approach looks for investment managers who deliver consistent results in their respective areas of expertise, and our selection process aims to differentiate manager “skill” from “luck.”

It is intuitive that higher active share results in a wider range of outcomes between outperformance and underperformance while funds with a lower active share are likely to produce more homogeneous results since they are more similar to their benchmark.

One could argue that investing in higher active share funds opens the typical investor up to the risk of greater underperformance with no uptick in expected return. Also remember that high active share funds are often associated with higher costs, indicating a lower expected return after fees.

In the meantime, there are two important takeaways. First, the concept is a direct measure of differentiation, not manager skill. And second, mutual funds that consistently outperformed their benchmarks on average had a high level of diversification. We believe this finding lends strong support to our multi-manager approach.

Our pioneering asset allocation study demonstrated that a portfolio’s mix of its underlying holdings—not market timing or stock selection—was the primary determinant of variation in portfolio returns. This research became a cornerstone of portfolio construction theory.

We believe that a diversified portfolio is one of the best ways to reduce risk and increase the odds that investors will remain focused and stick to their investment strategies in good times and bad. As always, investors should carefully consider all investment options and select investments based on their individual needs and goals. We have long played an industry-leading role in this and other areas, and will continue to do so in the years ahead.

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Important Information

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only. Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company.

There are risks involved with investing, including loss of principal. Diversification may not protect against market risk.

Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company. Neither SEI nor its subsidiaries is affiliated with your financial advisor.