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Equity Perspectives

video

Research has identified four key types of active management. Here’s a look at how they stack up.

Transcript

Welcome to Lord Abbett's The Active Approach. This is the first in a series of videos spotlighting the discipline of active equity management.

The Two Dimensions

Basically, active equity managers can either take it from the top, or start at the bottom. That's the crux of the two dimensions of active equity fund management, as established by research published by K.J. Martijn Cremers and Antti Petajisto.

The first dimension is factor timing, which involves weighting different factors believed likely to generate returns at particular times. Factors can include industry sectors, capitalization sizes, or others. To measure the first dimension, Cremers and Petajisto use the volatility of tracking error. Tracking error measures how much a fund's performance diverges from its benchmark. So if a fund heavily overweights a sector such as energy, for example, then the fund is likely to diverge more than if it matched the benchmark's weighting.

The second dimension of active management is security selection, in which the primary focus is on valuation and company fundamentals. The stock-picking dimension is measured using a metric called Active Share. Active Share is a concept that entails comparing the holdings and weightings of a fund in order to provide a numerical measure indicating how much a fund diverges from its benchmark. That is, along, with tracking error, it provides another indicator of just how active an active manager is.

Most funds employ a combination of the two approaches. And how far a fund leans in one direction or the other can be measured.

Equity mutual funds can be plotted along these two dimensions: Active Share on the vertical axis and tracking error on the horizontal axis.

The Four Types of Active Managers

Using these two dimensions, Cremers and Petajisto classify actively managed portfolios into four groups

1. "Concentrated managers" evidence high active share, but they also score high on tracking error. Although they actively pick stocks, they also overweight sectors or other factors, leaving them less diversified than other managers.

  • High Active Share
  • High Tracking Error
  • Concentrated Bets

2. "Moderately active" managers don't score high on either dimension, with only average scores for both active share and tracking error.

  • Least Active of Four Groups
  • Average Active Share
  • Average Tracking Error

3. "Factor timing" portfolios may encompass a range of strategies, which may include a high degree of active share—but not as high as some other approaches. Because their strategies result, intentionally or otherwise, in over- and underweighting sectors and other factors, they score high on tracking error.

  • Concentrated bets, whether intentional or not
  • Low-to-mid Active Share
  • High Tracking Error

4. "Diversified stock pickers," who score high in active share, rely largely on stock selection and less on generating returns by weighting macro factors such as industry sectors. That is illustrated by their low-to-midrange tracking error scores. They are diversified in the sense that they largely refrain from overweighting or making concentrated bets on sectors or any other factors.

  • Emphasize Stock Selection
  • High Active Share
  • Low-to-mid Tracking Error

What Do the Numbers Say?

Now that we've established the types of equity management, let's take a look at their average performance over time. Further research conducted by Petajisto on Active Share has demonstrated that of the four groups, only Diversified Stock Pickers beat their benchmarks during the 20-year period from 1990 to 2009, and they did so by an annual average of 1.39%. It should be noted that this result is after management fees were taken out. The other three forms of active management failed to best their benchmarks during this period. Concentrated Managers, for example, lagged by 0.89%, Moderately Active funds trailed by an average of 0.78%, and Factor Bettors missed by 2.19%.

Of course, this is not to say that other forms of active management cannot outperform at any given time. But on average, the diversified stock pickers performed better at beating their benchmarks during the period covered by the research.

Past performance is not a reliable indicator of future results.

Walter Prahl, Lord Abbett Partner and Director of Quantitative Research, sums it up this way: "What the active share research has revealed is that managers relying on factor timing are less likely, on average, to add value than managers who engage in stock picking." Prahl adds that “for those opting for passive portfolios, stock picking is a lot to give up."

Interested in learning more about active management? Visit lordabbett.com or download our Perspectives app for the iPad from the Apple App Store.

Research cited in this video:

K.J. Martijn Cremers and Antti Petajisto, "How Active Is Your Fund Manager? A New Measure That Predicts Performance," Yale Working Paper No. 06-14, March 31, 2009.

Antti Petajisto, "Active Share and Mutual Fund Performance," Social Science Research Network, January 15, 2013.

Active Share is a concept that entails comparing the holdings and weightings of a fund in order to provide a numerical measure indicating how much a fund diverges from its benchmark. That is, it provides one indicator of just how active an active manager is. An Active Share score can range from zero for a fund that matches its benchmark perfectly to 100 for one with no overlap whatsoever. Active Share can therefore be interpreted as the portion of a portfolio that differs from the benchmark. Active Share was developed by professors K.J. Martijn Cremers (formerly of Yale University) and Antti Petajisto (formerly of New York University).

Tracking error (or more formally, tracking error volatility) is commonly defined as the time-series standard deviation of the divergence between a fund return and its benchmark index return. A typical active manager aims for an expected return higher than the benchmark index, but at the same time wants to have low tracking error (volatility) to minimize the risk of significantly underperforming the index.

Active Share is a methodology used to evaluate a fund's actual performance and volatility against a benchmark. The methodology is not an indicator of how a specific investor's investment will perform. This should not be used as a tool or evaluation in making any investment decision. We strongly recommend that you consult with your financial advisor before making an investment decision. Neither diversification nor asset allocation can guarantee a profit or protect against loss in declining markets. Lord Abbett does not offer exchange-traded funds (ETFs) or index funds. An ETF is a security that tracks an index, a commodity, or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold. ETF products, like all investments, are subject to market risk, which may result in loss of principal. Index funds are constructed to match, or track, the components of specific market indexes, which can be volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.

The information in this presentation is being provided for general educational purposes only and is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general, nor are they intended to predict or depict performance of any investment or serve as a recommendation or offer to buy or sell securities. Any examples provided are for informational purposes only and are not intended to be reflective of actual results. There is no assurance that the investment process will consistently lead to successful investing.

Diversification does not guarantee a profit or protect against loss in declining markets.

Risks to Consider: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued and may not appreciate as anticipated. No investing strategy can overcome all market volatility or guarantee future results.

This broadcast serves as reference material for information purposes only; does not constitute an offer to acquire, solicitation for an offer to acquire, an offer to sell or solicitation for an offer to buy, any securities, nor is intended to be relied upon as a forecast, research, or investment advice on any securities, and cannot be used for any of the foregoing.

The views and opinions expressed by the Lord Abbett speaker are those of the speaker as of the date of the broadcast, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions and Lord Abbett disclaims any responsibility to update such views. Neither Lord Abbett nor the Lord Abbett speaker can be responsible for any direct or incidental loss incurred by applying any of the information offered.

The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Please consult your investment professional for additional information concerning your specific situation.

This broadcast is the copyright © 2014 of Lord, Abbett & Co. LLC. All Rights Reserved. This recording may not be reproduced in whole or in part or any form without the permission of Lord Abbett. Lord Abbett mutual funds are distributed by Lord Abbett Distributor LLC.

FOR MORE INFORMATION ON ANY LORD ABBETT FUNDS, CONTACT YOUR INVESTMENT PROFESSIONAL OR LORD ABBETT DISTRIBUTOR LLC AT 888-522-2388, OR VISIT US AT LORDABBETT.COM FOR A PROSPECTUS WHICH CONTAINS IMPORTANT INFORMATION ABOUT A FUND'S INVESTMENT GOALS, SALES CHARGES, EXPENSES AND RISKS THAT AN INVESTOR SHOULD CONSIDER AND READ CAREFULLY BEFORE INVESTING.

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