Active share helps investors identify just how active their equity managers’ portfolios really are, but it is also proving to be a versatile fiduciary risk management tool for plan sponsors by providing quantitative evidence in three areas of fiduciary oversight:
1. Ensuring plan assets are diversified.
While equity managers with complementary investment philosophies and styles can help diversify aggregate plan assets, sometimes things get out of whack. One manager’s stock pick can cancel out the sale of the same security by another manager, for example. And a plan whose assets are allocated across a variety of investment mandates and styles can still produce an equity aggregate that looks like a closet index fund. Both are symptoms of overdiversification.
By analyzing the active share of the plan aggregate versus its benchmark, sponsors can see how active—or not—the aggregate really is and take corrective action.
2. Hire and monitor investment managers.
Active share analysis is best-known for uncovering closet indexers—something most plan sponsors want to avoid. But active share has many other useful applications.
It can shed light on an active manager’s investment process by evaluating what type of active decisions a manager makes, identify how sectors contribute to the process and even help determine whether a manager’s chosen benchmark is appropriate for their portfolio.
Holdings analysis: How a manager achieves active share
The chart below illustrates the types of active investment decisions a manager has made to contribute to its portfolio’s active share:
By breaking out active share into the holdings categories shown on the right of the chart, you can see how a manager’s investment approach manifests in portfolio holdings versus the benchmark. In the above example, we see a portfolio where the largest active share is coming from avoiding certain securities held in the index. Virtually no active share is derived from underweighted positions in index securities.
This type of active share analysis can also be performed over various time series. The more consistent the pattern of active share by holdings types is over time, the more likely it is that the manager’s investment philosophy is being applied consistently.
Sector analysis: How sectors contribute to active share
The chart below illustrates the active share of each sector in the portfolio—demonstrating the extent to which each sector’s holdings vary from those in the index. The weights of each sector in the portfolio and the index, as well as the relative weight, are also displayed to provide context.
This type of sector-level active share analysis treats each sector as its own portfolio and does not take into account the weight of the sector in the portfolio. Any sector not held in the portfolio, like Sectors 9 and 10, above, has an active share of 100%, since that sector is completely (i.e., 100%) different from the index sector.
Benchmark analysis: Is a portfolio true to its benchmark?
If a manager is true to its investment mandate, the portfolio’s active share should be relatively low versus its primary benchmark, since its holdings have the most overlap with that index. Conversely, the portfolio should have a high active share versus a different style benchmark, demonstrating little overlap in holdings. If the lowest active share aligns well with the benchmark, that’s good news. If not, it could be an indication that something is wrong. Perhaps it should be monitored against another benchmark or perhaps the portfolio is drifting away from its mandate. Either case should trigger questions from the plan sponsor.
In the chart below, let’s assume the manager was hired to run an active small-cap growth portfolio using the Russell 2000 Growth Index as their primary benchmark—“index 1,” below. The plan sponsor runs an active share analysis of the portfolio versus the R2000 Growth, and also includes the Russell 2000, Russell Mid-Cap and Russell 2000 Value indices in their analysis.
The portfolio’s active share versus the R2000 Growth is the lowest of the four at 93.31%. The portfolio’s active share also increases with each additional benchmark—from 93.62% vs. the R2000 to 99.05% vs. the R2000 Value. This is powerful evidence that a) the manager is staying true to its small-cap growth mandate and b) the portfolio has not drifted into small-cap, mid-cap or value territory.
whether investment fees are reasonable.
Plan fiduciaries are charged with a responsibility to ensure plan investment fees are reasonable. Paying active management fees for a portfolio that is a closet index fund is a real and present danger for plan sponsors. Active share analysis helps fiduciaries quantify how “active” a portfolio is and make sure the fees they are paying are justified.
If a manager’s active share is less than 60% versus its benchmark, it is safe to say the portfolio is bordering on a closet index fund. The same is true of an aggregate portfolio. The prudent fiduciary will take corrective action to avoid paying active management fees for passive management.
This is the second article in a three-part series. Part One explained what active share is and how it is used as a portfolio monitoring tool. Part Three will examine how active share can help identify style drift in active portfolios.
Thusith Mahanama, CEO, Assette, provider of client communications solutions headquartered in Boston
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.Any opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.