How active should active asset management be? An increasingly popular argument contends that if you are going to be active, you should go all the way and be very active. The New York attorney general joined the debate recently when it asked large asset managers to publish their funds’ active share metrics to help investors determine whether active fund costs are justified compared with cheaper index funds. I wanted to explore that concept, and I also wanted to look at the reverse, which is not as often discussed: Should passive strategies be very passive, or should they incorporate active bets?
On April 9, I convened a panel of three industry experts: Martijn Cremers, professor of finance at Notre Dame and co-creator of active share; Ben Inker, portfolio manager and leader of the asset allocation team at GMO; and Ben Johnson, director of global passive strategies research at Morningstar. Our conversation has been edited for length and clarity.
John Rekenthaler: Martijn, can you explain your work on active share?
Martijn Cremers: Active share is a measure of how much security selection the fund engages in—a tool that compares the holdings of a fund to the holdings of a benchmark. Particularly, active share is the percentage of holdings (or portfolio weights) that doesn’t overlap with the holdings of the benchmark. Another measure, of course, is tracking error, which measures how different the returns have been.
I looked at active share in combination with other dimensions, such as fees, and I found that it’s not a problem to have low active share, if the fund is relatively cheap. As for why high active share funds may outperform, active share may matter more for funds that have better stock-picking opportunities, like small-cap strategies, and strategies that require the courage of one’s convictions, like being patient.
Rekenthaler: There are various ways of being active, right? Through security selection or concentrated portfolios, or by making big industry or theme bets, which might not trigger the active share measure.
Ben Inker: If you are making your bets in industry or country or regional ways, that is less likely to show up as really high active share than a highly concentrated portfolio of 10 or 20 stocks is. At GMO there isn’t a particularly strong correlation between our active share and our tracking error. We sometimes will have high tracking error, and sometimes we’ll have low tracking error, but the active share bounces around within a relatively narrow range.
Ben Johnson: It’s important to emphasize that active share is a descriptive statistic and to stop short of inferring that it implies some level of skill. There will be high active share management with managers who perform quite well and may be skilled, and there will be high active share management with managers who perform less well and may be unskilled or simply unlucky.
Cremers : I very much agree. Active share is not a measure of skill. However, if investors pay high fees for a fund, then they should expect that the fund is quite different than an index fund. The combination of having a low active share and high fees is probably the strongest predictor I’ve found for underperformance.
Inker: One of the really nice things about active share is that it doesn’t involve opinions. One person’s definition of active share, at least relative to a particular benchmark, is going to be the same as another’s.
But I want to pivot a bit to a different point. Even if a highly aggressive active asset manager has skill, that is no guarantee you are going to make money having hired him. Even skilled active asset managers will go through some periods where they are unlucky. Clients who can't take that kind of volatility should not hire those kinds of managers.
Rekenthaler: If we’re going to use highly active asset management, how should we do so?
Inker: Probably the most important factor is the confidence that the end investor has that the active share manager’s approach is a good idea. If the end client is lukewarm on whether tactical asset allocation works, they are going to fire an active tactical asset allocator during a period of underperformance. Institutional investors who have done a good job with highly aggressive managers tend to go in with a strong philosophical preference. They have hit upon a style in which they are confident in their ability to find talented managers, and they have been patient when those managers go through a tough period of performance.
Cremers : “Aggressive” needs to be carefully defined, and high active share doesn’t mean that the manager is necessarily aggressive. A lot of high active share managers do security selection in a way that’s well diversified and they may end up with total volatility that may not be higher than the benchmark. When thinking about security selection, what’s most important is that there must be something that the active share manager’s doing that is hard to do. There must be some frictions that prevent others from doing the same thing.
This blog post is adapted from an article that originally appeared in the June/July 2018 issue of Morningstar magazine. Read the full article or subscribe to the magazine for free.
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