The value of low active share managers
In our previous blogs we have argued that active share1, though a useful measure, is not the silver bullet many believe it to be. Active share; (a) is different from a measure of manager skill and (b) does not translate well to multi-manager investing. In our last conversation, we also pointed out that positive excess returns cannot be diversified away and we showed an example of how high active share managers, with strong track records and diversified excess returns, lead to lower tracking error and lower active share when combined but with an unchanged total excess return outcome.
Continuing our conversation with Director, Capital Markets Leola Ross let’s explore an additional topic: performance of lower active share managers. Most proponents of high active share believe lower active share managers are ‘closet indexers’ that cannot possibly outperform benchmarks. Our experience suggests otherwise.
Leola, what you have learned through your research about lower active share managers both on their own and as a part of a multi-manager portfolio?
Leola: We have seen many examples of successful low active share managers. In fact, we can draw on two illustrative examples from our portfolios. Consider Managers 4 and 5, and Portfolio 2 (a multi-manager portfolio of Managers 4 and 5) in the analysis below.2 We selected these managers because they exhibit relatively lower active share compared with peers and have both generated substantial excess returns. They are in the portfolio because our manager research doesn’t just screen them out based on their active share.
Let’s get to that reason in a moment. First, I have to ask, doesn’t this combination run counter to most of the research and media attention on active share?
Leola: Although we’ve seen good marketing, most research has been isolated to one region (US equities) and a single time period. We, and others, have observed a range of flaws (including combining small cap and large cap managers) in most of these assessments. Not surprisingly, once we expand the traditional analysis to different time periods and evaluate other regions, these results go away.
So, if low active share managers can perform well on their own, does it make sense to combine them into a multi-manager portfolio?
Leola: Absolutely, combining managers can make sense so long as these managers have solid excess return potential, diversify each other, and diversify the other managers in the portfolio. As seen in the above table, the combined portfolio has excess returns that are a weighted historical average of the two underlying managers but with lower tracking errors3 and even lower active share than either manager separately.
What sort of managers have low active share (they can’t all be closet indexers!)?
Leola: Typically, we find lower active share in quantitative (aka “quant”) managers who build portfolios with rules-based systematic strategies. Often their strategy is to exploit signals about certain types of securities they expect to outperform by taking small bets on a large number of such securities with the right characteristics. In this case, such managers aren’t looking for a star security and as a result of their approach usually don’t have high active share. By contrast, a fundamental (or “qualitative”) manager evaluates individual securities with greater depth and tries to identify those few star performers, rather than betting on a group of securities as a whole. The good news is, when combining different types of managers in a portfolio, quant managers’ approach usually diversifies fundamental managers’ approach. Because their processes are so different, it can be beneficial to have both in a fund. Even better news, we’ve observed that quant managers tend to have had some of the best performing active strategies when looked at over the past 3 and 5 years.
Summing it all up:
Just as combining high active share managers can lead to strong multi-manager excess returns despite active share falling, so too can single managers with low active share play a valuable role in investor portfolios. In both cases, the role that quant and fundamental managers play in diversifying a multi-asset portfolio is crucial. Remember: don’t discount the quants and other lower active share managers!
As always – when evaluating different managers as part of building a total portfolio – we think it’s critical to look at a manager’s process and potential for excess return, not a just a single metric.
1 Active share, also known as active money and/or commonality, is defined as the sum of differences between an active fund and a benchmark on a share by share basis. The greater the difference between the fund and its benchmark, the greater the active share
2 Managers 1, 2, 3 and Portfolio 1 introduced in the prior blog
3 Tracking error is the volatility of excess return over time.
4 Information ratio is the ratio of excess returns to tracking error.