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Market View

Stock picking is associated with outperformance when factor risk is constrained.

Active share,1 the widely cited measure of active management introduced in 2009, continues to make headlines. Industry newsletter Fundfire noted in April 2015, for example, that while some institutional clients will now consider only funds that exceed a minimum of active share, some consultants are arguing that high active share is no guarantee of superior performance.2 Given the continuing lack of clarity on the subject, we thought it would be useful to review some facts.

1. Active share measures how active a fund is on one approach to active equity management: stock picking.

The other broad approach—factor betting—is best measured via a fund’s tracking error. According to active share originators Martijn Cremers and Antti Petajisto,3 an active manager can beat his benchmark in one of two ways, either by stock selection or by factor betting. While stock picking involves making bets on individual stocks, factor betting requires temporarily overweighting factors believed to drive performance. These can be economic sectors, styles (e.g., value versus growth), sizes (e.g., small caps versus large caps), and any number of others. A fund manager might choose to overweight small caps if he believes they are about to outperform large caps, for example.

Cremers and Petajisto use active share to measure the stock-picking dimension of active management and tracking error to measure the factor-betting dimension. (Tracking error measures how much a fund’s price performance diverges from that of its benchmark.) 

2. Active share and tracking error are positively correlated, and at the highest levels of active share, tracking error rises dramatically.

Although active share and tracking error measure different aspects of active management, they are positively correlated. It’s possible for a fund to achieve a high score on active share without having a high tracking error, but funds that are in the top tier on active share are often in the top tiers on tracking error as well.4

In fact, tracking error tends to surge as active share reaches the highest levels. Chart 1 shows that in the large-cap value category, for example, as active share passes 80, tracking error begins to explode. This suggests that beyond a certain point, it’s difficult to add active share without adding tracking error in even larger amounts.

 

Chart 1. At Higher Levels of Active Share, Tracking Error Explodes
Active share as of 12/31/2011; three-year tracking error as of 12/31/2014

Source:  Morningstar.

 

3. Mutual funds with the highest active share tend to make factor bets—over- or underweighting such factors as style, capitalization, and sectors.

The reason tracking error rises when active share reaches the highest levels is that beyond a certain point, adding active share becomes difficult without taking on more factor risk. Concentrated funds, for example, have attracted attention for their very high active share, but their concentrated nature leaves them exposed to a variety of factor risks, according to Walter Prahl, Ph.D., Lord Abbett Partner & Director of Quantitative Research.

Portfolios with only 20 holdings, for example, can’t hedge out much of the risk associated with certain sectors, industries, styles, and other factors. Hedging out industry risk alone would probably require about 50 stocks.

The exposure to factor risk becomes more pronounced the more concentrated the fund becomes. Reducing a fund’s holdings can add to its active share, but past a certain point, the fund starts to add factor risk faster than it adds active share, said Prahl. “That point will easily be reached by about 50 names, which is well above what most fans of concentrated funds regard as the right target. A portfolio of about 20 names will inevitably have a lot of factor risk—it won’t be a [diversified] stock-picking portfolio but, in effect, a factor-timing portfolio.”

4. Historically, active share has been positively correlated with outperformance, while the effect of tracking error has been negative.

The explosion of tracking error that can occur at high levels of active share can have a detrimental effect on performance. As Table 1 indicates, the impacts of active share and tracking error on performance are opposite. Thus, the improved performance that could arise from the added active share may be offset by the negative impact of added factor risk.

 

Table 1. Effect of a Simultaneous 1% Increase in Active Share and Tracking Error on Annualized Excess Returns, 1992–2009

Source: Antti Petajisto, “Active Share and Mutual Fund Performance,” Financial Analysts Journal (July/August 2013).
Note: Bps = basis points; 1 bp is equal to 1/100 of 1%.

 

5. Historically, among high active share funds, only those that are diversified, or factor-neutral, have outperformed, on average.

The importance of factor risk and its effect on performance can be seen in Table 2. Concentrated funds, which are exposed to factor risk and, therefore, tend to have high tracking error, have, on average, failed to produce alpha. Funds taking a factor-betting approach have fared even worse. In contrast, diversified, or factor-neutral, stock-picking funds have outperformed (net of fees).

 

Table 2. Historically, on Average, Only Diversified Stock Pickers Have Outperformed
Average active share, tracking error, and alpha, 1990–2009


Source: Antii Petajisto, “Active Share and Mutual Fund Performance,” Financial Analysts Journal (July/August 2013).

 

This is the whole point of the active share research, said Prahl. “More active share isn’t necessarily better if it comes with much more tracking error. Why is that? Because active share is a pretty good measure of stock picking, while tracking error tends to be more related to factor exposure. And the research shows that stock picking has worked, on average, while factor betting has been much more difficult.”

 

1 Active share is computed by summing the absolute values of differences between a portfolio’s holdings and those of its benchmark and dividing this by two. The result can be interpreted as the percentage of the fund that differs from the benchmark.
2 “Active Share May Be Overhyped with Institutional Investors,” Fundfire, April 22, 2015.
3 K.J. Martijn Cremers and Antti Petajisto, “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” The Society for Financial Studies, 2009.
4 Antti Petajisto, “Active Share and Mutual Fund Performance,” Financial Analysts Journal (July/August 2013).

 

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