Exposing the closet indexers
The traditional way of analysing managers has been to measure their tracking error by looking at the volatility of the difference between a portfolio return and its benchmark index return. This works with managers who take a thematic approach to their fund. But a fund which is a pure stock picker and looks for a good company will be quite diversified by industry. In this case, their tracking error may be quite low and lead us to (wrongly) assume that they aren’t taking much active risk.
Active share There is an alternative which has recently emerged – the concept of ‘Active Share’. This approach compares the portfolio holdings of a fund to its benchmark index. To understand a manager’s ‘Active Share’ we look at the stocks the fund holds and measure how overweight (long) or underweight (short) they are when compared to the index. By doing this we are trying to understand how many ‘active decisions’ a manager has taken about the stocks in their portfolio. We can then use this to measure our managers and thus how active they are. For example, a fund might be 100 per cent invested in the FTSE 100 but the manager has decided to underweight 40 of the stocks and then used that ‘saved’ portion to overweight or go long on another 40 stocks. This means that the ‘Active Share’ of the portfolio is 40 per cent. If a fund doesn’t actually short, the Active Share will always be between 1 and 100 i.e. for an index fund there are no weightings so the Active Share would be zero. Determining potential By using ‘Active Share’ we can compare the potential for generating alpha rather than just basing our decision on how the fund has performed – which is what Tracking Error does. For example, if a fund holds very similar stock weightings to the index, the potential for generating alpha or outperforming that index is limited. By combining Active Share and Tracking Error we can plot a fund in two dimensions to get a comprehensive picture of active management as illustrated in the chart below. A manager with low Tracking Error and low active share is a closet indexer – i.e. their performance as measured by tracking error will be very similar to the benchmark and their holdings will also be very similar to the benchmark – they aren’t taking much active risk. But what does Active Share actually tell us? A US study found that funds with the highest active share exhibit some skill and pick portfolios which outperform their benchmark by 2.00-2.71 per cent per year . In comparison, tracking error, by itself, is not related to fund returns. If anything, higher Tracking Error predicts slightly poorer performance. Therefore not all units of active risk should be rewarded by return but the dimension captured by Active Share can be. It thus makes sense to seek a manager with high Active Share and give yourself the best possible chance of yielding alpha.
