Joseph Mariathasan asks what investors should be prepared to pay for active management approaches  

At a glance 

• It is claimed that many self-proclaimed active managers are in fact closet trackers.
• Active share provides a way of distinguishing between genuinely active managers and closet trackers.
• Calculating alpha implies some assumptions on appropriate market indices. 
• The question facing investors is whether now is the time to ramp up risk.

How much is active management worth? That question is becoming more controversial with the rise of smart beta and alternative beta strategies. These purport to give exposure to many of the risk premia that had previously been the preserve of active managers but at a far cheaper cost. 

It is also often claimed that many of those who claim to be active managers are, in practice, closet indexers. This is the view of Nathan Gelber, CIO at Stamford Associates. “There are not enough genuine high-quality active managers around,” he says. In his view, large firms are just trying to gather assets and keep them for as long as possible. “They get sacked, in the main, if they underperform badly, so they can minimise their own business risk by sticking closely to the index,” he says. “We rarely recommend going to the large firms for true active management and only in case we are able to find outstanding talent. It is preferable to opt for a well-constructed index fund from them rather than a badly conceived active portfolio.” 

But how can active management be distinguished from index-hugging approaches that may be charging active fees? 

What has become popular in recent years as a metric for differentiating the truly active managers from closet indexers is the concept of active share. Martijn Cremers and Antti Petajisto, two academics, defined active share as the “fraction of the portfolio that is different from the benchmark index” and stated that “it provides information about a fund’s potential for beating its benchmark index”. Active share is calculated by taking the sum of the absolute value of the differences of the weight of each holding in the manager’s portfolio and the weight of each holding in the benchmark index and dividing by two. An index fund would then have an active share of zero, while a fund with no stocks in the benchmark would have an active share of 100%. 

It has achieved prominence particularly because some early studies seemed to indicate that high active shares could predict outperformance. Some mandates have even stipulated a minimum value for active share. What Gelber also finds useful is to assess at a more granular level the distribution of individual bets in terms of individual stock positions versus the weights in the index.

“Active share is something we believe in as a concept,” says Damien Loveday head of the diversified strategies team at Towers Watson. But it has aroused some controversy. AQR, a global asset management firm, questions its usefulness in a recent paper. “We find that the empirical support for the measure is not very robust and the difference in outperformance between high and low active share funds is driven by the strong correlation between active share and benchmark type. Active share correlates with benchmark returns, but does not predict actual fund returns; within individual benchmarks. Active share is as likely to correlate positively with performance as it is to correlate negatively”. 

Clearly, as Todd Schlanger, in Vanguard’s investment strategy group, says, to outperform a benchmark index, it is not enough to be different: the portfolio manager’s bets must also be accompanied by manager skill, and the overweights must be in the outperforming stocks. “Active share by itself does not indicate whether a fund will outperform an unmanaged benchmark,” he says. 

Indeed, just because a monkey throwing darts produces a different portfolio from the index does not mean it will outperform. The point that Loveday makes, however, is that academic evidence seems to indicate that decent active managers generate the vast majority of their alpha from their largest or highest concentration positions, while the tailing positions add very little alpha: “The problem often is that the potential alpha can be reduced by poor portfolio construction and, in particular, by not giving the highest conviction bets the greatest weighting.” Keeping bets on for long enough can also be an issue.

Martijn Cremers and Ankur Pareek in a recent draft paper find that among high active share portfolios whose holdings differ substantially from their benchmark, only those with patient  investment  strategies  (with holding durations of over two years) on average outperform over 2% a year (see article on patient capital, page 70). Funds trading frequently generally underperform, including those with high active share. Among patient funds, separating closet index from high active share funds matters, as low active share funds, on average, underperform even with patient strategies.

What should be a fair price for active management? Stamford Associates says managers need to have their interests aligned with those of their clients by having an element of performance fees. Contracts for equity fund management would typically be structured with base fees of between 50-60bp a year together with a performance fee of between 7.5% to 10% of the net outperformance of an index after fees and expenses, subject to high watermarks. 

Headline fees, though, can be misleading, says Loveday. “The way we assess fee structures is to look at what proportion of the gross alpha produced is paid out as fees,” he says. “This requires us to break down the components of return in any strategy into what is just a beta return of any type, which should be able to be accessed very cheaply, and what is pure alpha.” 

Clearly, calculating alpha does imply some assumptions on appropriate benchmarks indices. To outperform an index does require being different from the index, but the converse does not have to be true. What active share does give is a metric, along with others that can be used to appreciate whether there is potential to generate alpha. 

If investors should only be paying significant fees for alpha rather than for market beta accessible via products such as exchange traded funds, then what is a fair split between the managers and their investors for the alpha that the manager generates? “Towers Watson asked a room full of both investors and asset managers what they thought was a fair number,” says Loveday. “The investors thought the managers should be paid 20% of the alpha generated. The managers thought they should be paid 50%.” Loveday also sees that in an ideal world, a fee of 30% of the alpha generated seems about right. “Paying out anywhere more than 50% of pure alpha would be seen as excessive,” he says. But as he points out, in the real world a significant number of managers take well above half of the alpha they generate in fees.

“Anyone producing unleveraged alpha with no risk premium embedded within it of 4% to 5% is doing very well in a world where risk premiums in credit and equities and alternative investment are lower than in the past,” says Loveday. Total returns would be expected to be less than have been achieved historically. But from a risk taking perspective, there have been plenty of opportunities to make money in the past few years with massive dislocations in markets, increasing dispersion, increased volatility and a divergence in central bank policies, all of which make it easier for active managers to generate alpha. 

The question that investors need to answer for both themselves and their managers, says Loveday, is whether, in a period of episodic volatility, now is the right time to be ramping up risk? For some hedge funds that have grown large and are generating significant management fees, there is the temptation to reduce their volatility against benchmarks and hence their own business risk. But for their investors, paying high fees for reduced alpha potential is not an attractive proposition. Yet measurements of gross alpha paid out as fees can only make sense if they are evaluated over time periods of at least three years and preferably more than five. Having the patience to wait that long before you decide to sack a manager whose fees are seen as too high a proportion of their alpha may be the biggest challenge.