Charlotte Moore tests the limits of quantitative measures of ‘activeness’ in portfolio management, and finds that a good dose of qualitative common sense is a vital part of the manager selection process

The rise and rise of the ETF along with an increasing focus on the cost of pension provision has put a spotlight on the benefits of active management.

Passive product providers are more than happy to pour opprobrium on active fees that cannot be justified by performance. They point out that many supposedly actively-managed funds are, in fact, ‘closet index trackers’. 

Yet the pensions industry bears much responsibility for this – many active managers are told to adhere to a tight tracking-error target. Eric Colson, CEO of Artisan Partners, says: “Giving fund managers a tracking-error target is appealing to pension schemes because it gives them a sense of control.” 

But this sense of control is an illusion. If a fund’s performance is tightly benchmarked to an index, then it behoves the fund manager to maintain a portfolio that closely mirrors that index.  

“For a fund to attempt to outperform a benchmark, it has to be different to the index,” as Ayesha Akbar, a portfolio manager for Fidelity Solutions, puts it. 

If a tight tracking error target causes fund managers to ditch their active principles and become closet indexers, then one way to assess how actively a fund is run is to measure its tracking error – in theory, the greater the error, the more active the manager. But this measure has its flaws. Tracking error looks at return differential – essentially it is the deviation between the performance of the fund and the benchmark, which comes under the influence of factors such as cross-sectional volatility, or how correlated the performance is of all the stocks in the market.  

“There is not much point in betting on one stock versus another if the performance is highly correlated – the performance differential will not be significant,” says Akbar.  

As a result, the ability of tracking error to measure how active a fund’s risk and return is will vary over time, depending on the level of stock performance correlation. This is where a newly-formulated measure called active share may be useful. Rather than looking at the performance deviation from the index, active share measures the weight of a stock in a portfolio relative to its proportion of an index. That makes it more stable than tracking error, as managers picking stocks tend not to vary those positions very significantly over time. But active share also has its Achilles heel – it is influenced by the composition of the market-cap weighted index.  

“If the market cap-weighted index is very concentrated, then the more diversified managers, such as small-cap managers, will have a much higher active share than if the index was less concentrated,” says Akbar. “It’s impossible to accurately assess active share without looking at the benchmark and the asset class that it is being compared against.” 

Akbar argues that the best solution is to use both measures together, as the combination can provide useful insights. “Equity active management can be divided into those who are making stock bets or those who are making asset allocation decisions, whether that is country or sector selections,” she says. “Active share is a good measure for identifying those managers who are stock pickers, whereas tracking error tends to be better for selecting asset allocators.” 

The different combinations of high or low tracking error with high or low active share are characteristic of different management styles. For example, high tracking error and active share are typical of concentrated funds. Funds with low active share but high tracking error would be typical of a manager who is taking a view on specific sectors or regions, while high active share and low tracking error is characteristic of quantitative strategies with small allocations to a large number of stocks. Using tracking error and active share can help investors determine whether active managers invest according to their stated philosophy – if both tracking error and active share is low, the fund is not being actively managed. 

But not only does active share in combination with tracking error enable a pension scheme to ensure it is not paying active fees for an index tracker, it can also be used to try to select those funds which will outperform. 

Simon Laing, head of US equities at Invesco Perpetual, says: “Academic theory shows that a US fund with a high active share is more likely to outperform the index over time.” But for that to happen the fund has to have a very high active share, he adds. “If a fund had an active share of only 50%, then only half of the fund can contribute to excess performance. We think that a fund like that faces a challenge to outperform over the long term after fees.” 

For a US fund to outperform over the long term, Laing says that active share needs to be at least 80%. “If you start to cut the data in this way, then you have a much better chance of choosing a fund which will outperform over the long term.” 

Both tracking error and active share have an obvious limitation – they still compare managers to a benchmark index, which introduces a conflict of interest. The manager is instructed to take an active stance, yet must also keep one eye on the performance of index – a performance straitjacket forcing the manager to dilute its investment strategy. For a manager to be truly active, an unconstrained mandate is the only solution. 

“For many years we have steered away from active managers with low tracking error or low active share and towards unconstrained managers,” says Tim Giles, a partner at Aon Hewitt. “If a manager does not believe in a stock, rather than underweighting it, they should not hold it.” 

While high active share is useful tool for spotting those with unconstrained investment style, it’s not the only tool that should be used – a more qualitative approach is also needed. “The reasons for a manager to be able to outperform in the future cannot simply be predicted by either active share or tracking error,” Giles says. “We look for managers with high conviction portfolios who have a clear rationale for holding each stock. These managers will tend to have a portfolio of 30 or 50 stocks in a global portfolio, rather than the 3,000 which make up the MSCI All-World index.” 

But this is not always the case; some unconstrained managers have large, well-diversified portfolios of shares that are under-represented in the index. One that Aon Hewitt rates highly owns 700 stocks out of a universe of 15,000, for example. 

“We are looking for managers who buy stocks for any reason other than a stock is a constituent of a particular benchmark,” says Giles. Aon Hewitt  would run from an active manager if the reason for outperformance or underperformance was not consistent with its investment process, he adds. 

Finding managers who hold stocks for good reason is not only about choosing those with a clear investment process – some claim it also helps to select those which are more likely to outperform.  

Tom Howard, CEO and director of research at AthenaInvest and an academic who has dedicated his career to studying the performance of active managers, says that the number of stocks in a portfolio is not a good indicator of its level of conviction; rather, investors should look for a combination of a high proportion of the portfolio consisting of stocks that overlap the universe of stocks that suit the managers’ stated strategy or style, which AthenaInvest has identified by categorising hundreds of mutual funds according to different strategy ‘pools’.  

“Our measure of consistency is based on the percent of ‘own-strategy’ stocks held by the fund, with the higher the percent the better,” he says. “This consistency measure is predictive of future fund returns.” 

Ultimately, the lesson from experience seems to be that no one quantitative measure, nor even the right measures in combination, is sufficient to assess the true ‘activeness’ of a fund manager. A portfolio with a large number of stocks can have a high active share and high style conviction, just as a portfolio with 20 stocks can be chosen at random: the number of stocks is not, in itself, a measure of ‘activeness’. How does a manager describe his or her strategy, and to what extent do the stocks in the portfolio express that strategy? Why pay someone to do something, and then tie their hands?