Statistics can help trustees figure out if a money manager is actively managing a fund s investments or is actually a closet indexer.

Transcription

1 Active Share: Put Some Moneyball in Next Trustee Meeting by Thusith Mahanama Statistics can help trustees figure out if a money manager is actively managing a fund s investments or is actually a closet indexer. MAGAZINE Reproduced with permission from Benefits Magazine, Volume 51, No. 10, October 2014, pages 14-20, published by the International Foundation of Employee Benefit Plans ( Brookfield, Wis. All rights reserved. Statements or opinions expressed in this article are those of the author and do not necessarily represent the views or positions of the International Foundation, its officers, directors or staff. No further transmission or electronic distribution of this material is permitted. Subscriptions are available ( 2 PU pdf/1214

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3 Here in Boston, we take baseball seriously. Very seriously. So in 2003 when then-new Red Sox owner John Henry hired Bill James, the founder of sabermetrics and all things baseball stats, traditionalists were skeptical. Sure, this ultra-nerdy approach to America s favorite pastime had given the lowbudget Oakland A s a way to compete in the early 2000s a feat celebrated in the book, and later movie, Moneyball but would it work in a big-money market like Beantown? Ten years and three World Series rings later, the answer clearly is yes. Statistics can do the same thing for plan fiduciaries. OK, they won t get a fund a World Series ring. But they can make a trustee s job easier by providing an objective way to evaluate talent in this case, money managers whose returns are based on skill, not just luck. And they can ferret out closet indexers the investment equivalent of a big-name, highpriced slugger who finishes the season with more strikeouts than hits. Yes, statistics can be complicated. They involve equations that only a physicist or mathematician could untangle. Money managers and consultants throw around terms like Sharpe ratio and standard deviation of return as if they were mystical incantations. But like most things in life, there usually is a simple concept behind the jargon. A very simple and powerful investment statistic, active share, is an example. Active Share: A Little Background About the time the Red Sox were winning their second World Series ring of the 21st century, finance professors Martijn Cremers and Antti Petajisto were trying to find out how to tell which mutual fund managers were likely to learn more >> Education Trustees and Administrators Institutes February 9-11, 2015, Lake Buena Vista (Orlando), Florida Visit for more information. Investments Institute March 9-11, 2015, Rancho Mirage, California Visit for more information. Investment Basics Visit for more information. outperform in the future. In the process, they developed a new statistical measure they called active share and went on to conclude that managers with an active share of 80% or higher tend to outperform their benchmarks after fees and do so with persistence. 1 Since then, active share has been the subject of further research by Cremers, Petajisto and others. There is still some debate as to whether it can predict managers that are likely to outperform, but there is one thing everyone agrees on: Active share is an excellent way to identify whether a manager is a closet indexer. Identifying truly active managers is a constant challenge for plan fiduciaries and trustees. Since the market meltdown of , more managers are staying close to their benchmarks in an effort to avoid underperformance. According to a followup study by Petajisto, by 2009 approximately one-third of all U.S. equity mutual funds were actually closet index funds. 2 What Is Active Share? The idea behind active share is simple: In order to produce returns that beat a benchmark, like the S&P 500 index, a portfolio must be different from the benchmark. In order to be different, a manager must make a decision and act upon it. Passive managers make no active decisions their job is to replicate the index and produce about the same returns. That s why their fees are low. There are four types of actions a manager can take to be different from the benchmark: 1. Hold securities that are not in the index. Example: Manager holds XYZ stock, one that isn t in the index. 2. Hold securities that are in the index, but hold more of them than the index does. Example: ABC stock is 10% of the index; ABC stock is 20% of the manager s portfolio. 3. Hold securities in the index, but hold less of them than the index does. Example: ABC stock is 10% of the index; ABC stock is 5% of the manager s portfolio. 4. Not hold securities that are in the index. Example: ABC stock is 10% of the index; manager s portfolio doesn t own any ABC stock. Obviously, comparing the holdings of a manager s portfolio with the holdings of the benchmark index is the key to active share. It measures how much of the portfolio is active that is, different from the benchmark as a result of 16

4 the manager s investment judgment. (If you re the type who loves a good formula, you can see the active share calculation in the sidebar.) Active share is expressed as a percentage, on a 0% to 100% scale. In a perfect world, an index fund would have an active share of 0.0%, meaning that 100% of the portfolio overlaps with its benchmark and 0.0% of the portfolio holdings are different from the benchmark. Of course, the world isn t perfect. In reality, the typical index fund has an active share of 20%, meaning that 80% of the portfolio is exactly the same as the benchmark. So, what percentage of active share should trustees look for in a manager s portfolio? According to Cremers, the number varies by manager style. In a recent Wall Street Journal article, he said that an active share of at least 60% is good. Large cap managers should be in the 70%-plus range; mid cap managers in the 85%-plus range; and small cap managers should have an active share in excess of 90%. 3 How Active Share Helps Fiduciaries Active share can help investors identify just how active their managers portfolios really are. For plan trustees, active share can help fulfill three important fiduciary responsibilities: 1. Ensure plan assets are diversified. A fund s investment committee and consultants work hard to create a diversified mix of investment assets, styles and approaches for the fund. Knowing the active share of the fund s equity managers can identify portfolios that are converging close to the index, drifting away from their style mandate or otherwise affecting the overall asset allocation targets of the fund. 2. Determine whether investment fees are reasonable. Active managers deserve to be compensated for their skill and judgment. But paying active management fees for a portfolio that is a closet index fund is unreasonable. Active share analysis helps fiduciaries quantify how active a portfolio is and make sure the fees they are paying are justified. 3. Hire and monitor investment service providers. Active share analysis can help plan fiduciaries identify and eliminate closet indexers from consideration during new manager searches. Ongoing active share monitoring can tell trustees whether their managers continue to deliver active value to the plan and maintain their conviction to their specific investment mandates. Using Active Share to Analyze a Manager s Active Contribution The accompanying figures illustrate a few of the ways plan fiduciaries can use active share to evaluate new manager candidates and monitor existing active managers. Calculating Active Share for Your Funds Active share can be calculated as follows: Active Share = 100% - Overlapping Weights [portfolio, i and index, i] 1 Plan trustees and fiduciaries should ask to see active share numbers for their equity portfolios. Many investment consultants now provide active share analysis of manager portfolios, and more managers are taking the initiative and including active share in their client communications and reporting. Figure 1 Active Share and Overlap With Benchmark: Point in Time 6.69% 93.31% Endnote 1. This formula is an alternative to the original formula presented in the 2009 paper by Cremers and Petajisto. In correspondence between Martijn Cremers and the author on January 8, 2014, Cremers stated that he now prefers this alternative formula for active share. Active Share Overlap october 2014 benefits magazine 17

5 Figure 2 Active Share by Holdings Type vs. Benchmark: Point in Time 46.67% takeaways >> To produce returns that beat a benchmark such as the S&P 500 index, a portfolio must be different from the benchmark. By 2009 about one-third of U.S. equity mutual funds were actually closet index funds, as more managers stay close to their benchmarks in order to avoid underperforming. To be different from the benchmark, a manager can hold shares not in the index or not hold shares that are in index, or hold the same shares but in greater or lesser amounts. Fiduciaries need to be sure the manager has selected a benchmark appropriate for the portfolio strategy. Active share can help trustees ensure plan assets are diversified, determine whether investment fees are reasonable and hire and monitor investment service providers. Active Share and Overlap With Benchmark: Point in Time Figure 1 illustrates the active share of the portfolio (93.31%) as well as the portion that overlaps the benchmark index (6.69%). In this example, the portfolio has a high active share as of the holdings date, which indicates active judgments are being made. Active share is always measured 0.09% 11.33% Not in Index, Held In Index, Overweight In Index, Underweight In Index, Not Held 35.22% against the benchmark index for the portfolio. It is, therefore, important that fiduciaries make sure the manager has selected a benchmark that is appropriate for the portfolio strategy under consideration. (See Figure 3, which shows how active share can help verify benchmark fit.) Active Share by Holdings Type vs. Benchmark: Point in Time Figure 2 lets trustees see what type of active investment decisions their manager has made to contribute to active share. By breaking out active share into these holdings categories, you can see how a manager s investment approach plays out in portfolio holdings vs. the benchmark. Figure 2 shows a portfolio where the largest active share is coming from avoiding certain securities held in the index (green area) and virtually no active share is derived from underweighted positions in index securities (red area, which is hardly visible because the slice is very small). Portfolio Active Share vs. Multiple Indexes: Point in Time Figure 3 is a useful way to see how well a manager s portfolio reflects the style of its chosen benchmark as well as other indexes. If the manager is true to its investment mandate whether growth, value, small, mid or large cap or other the portfolio s chosen benchmark, Index 1 in Figure 3, should be the index that results in the lowest active share for the portfolio among the displayed indexes. That makes sense, since the portfolio should have more overlap with that index than any other. Conversely, the higher the active share of other indexes, the less like them the portfolio is. In other words, trustees have both positive and negative proof that the manager is or isn t staying true to its style mandate. For example, let s assume a fund has hired a manager to run an active small cap growth portfolio. The manager s primary benchmark is the Russell 2000 Growth Index. The trustees decide to include the Russell 2000 Growth, Russell 2000, Russell Midcap 18

6 Figure 3 Portfolio Active Share vs. Multiple Indexes: Point in Time % Active Share (%) % 93.62% 95.23% <index 1> <index 2> <index 3> <index 4> and Russell 2000 Value indexes in the analysis above. If an index other than the R2000 Growth results in a lower active share than the fund s primary benchmark, it is an indication that the portfolio has drifted into the style represented by that index. If not, trustees have point-in-time evidence that (a) the portfolio reflects a small cap growth bias and (b) the portfolio has not drifted into a small cap, mid cap or value territory. Portfolio Active Share vs. Multiple Indexes: Time Series Figure 4 shows how a portfolio conforms to the style indicated by its primary benchmark and other indexes over time. Portfolios that consistently demonstrate the lowest active share versus their primary benchmark are likely managed through a disciplined investment philosophy and process an important consideration when evaluating managers. In the figure, this portfolio s primary benchmark index, Index 1, is shown by the thick blue line. Obviously, this hasn t been the one with the lowest active share in the past, but the portfolio is beginning to align with its primary benchmark as of the latest period. Is this due to style drift or are there other reasons why the portfolio didn t align with its primary benchmark in the past? Perhaps the portfolio s strategic mandate changed during the period covered by the chart, or reallocations of cash into or out of the portfolio temporarily disrupted the manager s investment discipline. Both could explain the early periods Figure 4 Portfolio Active Share vs. Multiple Indexes: Time Series Active Share (%) <index 1> <index 2> <index 3> <index 4> october 2014 benefits magazine 19

7 << bio Thusith Mahanama is a co-founder and CEO of Assette, a Boston, Massachusetts firm that helps institutional firms communicate with their clients. He previously was responsible for managing information technology at Frontier Capital Management Company in Boston where he created one of the industry s first online client communications systems that provided daily portfolio data to clients. Mahanama has a B.S. degree in information systems and marketing from the University of Wisconsin-Superior and an M.S. degree in management information systems from Boston University s Graduate School of Management. of misalignment with the primary benchmark in the above chart. Structural changes to the composition of the benchmark index can also create misalignments, although these tend to be shorter term anomalies and smooth out over time. Of course, perhaps the portfolio simply has a history of style drift. No matter what the rationale in this example, having access to this type of historical active share information gives trustees the information they need to engage in a meaningful discussion with their managers about how outside factors affect their portfolio, the discipline of their investment process and their commitment to style consistency. Conclusion Today, Bill James sabermetrics are used by virtually all Major League Baseball management and many fantasy baseball clubs, as well as a way to objectively evaluate and manage talent. And in the institutional investment world, statistics are doing the same for plan fiduciaries and trustees. Active share, for example, provides a new perspective on how and where managers differ from their benchmark and can offer powerful evidence of a manager s active contribution to returns. Last, but certainly not least, active share helps plan fiduciaries carry out their primary responsibilities to maintain a diversified fund, hire and monitor qualified investment managers and make sure they are getting full value for the active management fees they pay. The bottom line is that active share is a must-have statistic for plan trustees and fiduciaries who want the benefit of the latest thinking in portfolio analysis and attribution. If a fund s investment managers are not providing trustees with active share information for their portfolios, trustees may want to consider asking them to include it as part of their standard performance reporting package. Endnotes 1. Martijn Cremers and Antti Petajisto, March 31, How Active Is Your Fund Manager? A New Measure That Predicts Performance (March 31, 2009). AFA 2007 Chicago Meetings Paper; EFA 2007 Ljubljana Meetings Paper; Yale ICF Working Paper No Available at 2. Antti Petajisto, Active Share and Mutual Fund Performance. NYU. Stern School of Business. Working Paper Series. Available at ssrn.com/abstract= Joe Light, January 18, And the Next Star Fund Manager Is... Wall Street Journal. 20