When market conditions become more challenging, the skills of an active fund manager can come into their own. Put simply, an active approach introduces a subjective element, such as in-depth research and forecasting, to uncover winners and losers. Many investors select funds on the basis of past performance (which is no guide to the future!) but it can be useful to look at other indicators to assess a manager’s chances of outpacing the relevant index.
Although a number of metrics are available, a relatively new addition is Active Share. The traditional measure of the degree of active management is ‘tracking error’ which tells us how closely the performance of a portfolio follows its benchmark index. In contrast, Active Share demonstrates how different the constituents of a portfolio are from its benchmark, or how ‘actively managed’ a fund is. A score of 100% indicates the fund’s holdings are completely different, whilst 0% means they replicate the Index.
Adding value with Active Share
The most common way a fund manager seeks to add value is by adopting a high Active Share strategy. This can be with either a diversified or a concentrated portfolio. The former will hold many stocks from the index but in different proportions to reflect the managers’ views. The latter holds a smaller number of stocks and may exhibit greater volatility (or risk) but with the potential for higher returns if their picks are successful. If you are paying higher fees for an actively managed fund you will naturally want to be assured that your manager is behaving in a truly active fashion.
Generally speaking, over 80% is considered to be a high Active Share. Comparing the figure between Funds in the same sector may be useful but bear in mind that some sectors are likely to have lower figures. For example, if the benchmark has relatively few stocks, like the FTSE 100, the active share should be lower than a Global Smaller Companies index which may have a universe of thousands of stocks.
Furthermore, Active Share may vary over time. When the largest stocks within a benchmark look relatively attractive, fund managers are likely to take advantage by having more in common with the benchmark. This would reduce the fund's Active Share. Furthermore, risk management controls may impose limitations on the extent to which a manager can deviate from a given benchmark.
Active managers tend to use a ‘bottom-up’ investment process, which focuses on finding best stock ideas and may exclude entire parts of the market. By measuring Active Share, investors can get a clearer understanding of exactly what a manager is doing to drive performance, though it doesn’t guarantee success. When a portfolio differs significantly from the index, returns can also diverge for prolonged periods. Indeed, even the most skilled managers can go through periods of underperformance when their style is out of favour.
While high Active Share is likely to exhibit short-term volatility it tends to do better over the long-term. However, there is likely to be considerable variability around this average. There’s no doubt that fund managers need to do things differently in order to outperform their benchmark, albeit history tells us that most value is added by a relatively small group of managers. Anything that increases transparency has to be positive but should not be used in isolation. Active Share is a useful tool but should be considered in conjunction with other data such as the fund's investment objective and the manager’s long-term track record.
Factsheets can help
Helpfully, a growing number of providers now publish Active Share figures on their factsheets including Neptune, Fundsmith, Liontrust, Baillie Gifford, Man GLG and Columbia Threadneedle (the latter not for the entire range). Even if a fund doesn’t produce this, it will list its top 10 holdings and their weightings compared with the benchmark, which at least gives some idea of how punchy their style is. Many funds will include in their objectives approximately how many stocks they intend to hold. Examples of funds known for their high conviction, concentrated portfolios are Lindsell Train UK Equity, JOHCM UK Dynamic and Fundsmith Equity.
Watch out for closet trackers!
I expect to see this metric produced more widely in the future and suspect it is helping to put an end to ‘closet trackers’ which charge for active management but do little more than hug the index. These are likely to have an Active Shares below 60% and are also being exposed by MiFID II’s focus on costs and charges. Premier Asset Management estimated that, by late 2017, less than 20% of UK Funds were closet trackers, down from nearly 30%. Meanwhile, 60% were active or highly active, and 22% were genuine trackers.
A growing number of investors prefer to stick with the simplicity and surety of a genuine passive fund; while it won’t beat the index, it will not underperform much due to very low charges. Of course, as cynics would point out, in testing times who wants to track a falling market?
Ultimately, performance is dependent on the quality of investment decisions a fund manager makes, rather than how far they deviate from a benchmark. Fund rating companies can do a lot of the legwork for you as part of their research process. However, if you still find the choices overwhelming it may be worth considering a Multi-Manager fund where experts apply objective and subjective analysis to identify best-in-breed fund managers.
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