I’ve been reading lately that Europe is in the midst of a regulatory hunt for money managers who profess to be active managers and are charging high fees for this service, while doing nothing of the sort. Rather, they are “closet” indexers–meaning that their portfolios look, for all intents and purposes, like their benchmark indices.
I can understand the horror EUers must feel at the wealth devastation wrought by European active fund managers, whose performance, both from my experience and the published figures I’ve seen, I regard as far weaker than their US counterparts’ (who admittedly don’t cover themselves in glory). Being charged high fees for poor outcomes must sting. On the other hand, the self-aware EU manager must realize that an index fund is the best product he’s capable of producing for his client. So in a funny sense the closet indexers are doing their clients a favor–except for the fee part.
But that’s not what I want to write about.
The tool regulators are using to detect closet indexing is called Active Share (AS).
It’s something I began using to control the risk in my portfolios in the 1980s, while working at TIAA. The advent of more powerful computers spawned its widespread use in the industry through performance attribution software during the following decade. But it only earned its capital letters when two Yale academics published an article (“How Active is Your Fund Manager? A New Concept That Predicts Performance”) about the concept in 2009.
The idea is straightforward. Find all the positions where the portfolio holds more than the index weighting and total all the “extra” money in those positions (if the manager holds something not in the index, the entire position counts as extra). Do the analogous thing with positions where the portfolio holds less than the index weighting. Take the absolute value of both sums, add them together and divide by two. Calculate the result as a percentage of the total portfolio value. The result is the portfolio’s AS.
The index has four stocks, A, B, C and D. Each has the same 25% weight.
Each portfolio manager has $100 to manage.
Portfolio manager X puts $25 into each stock. He has an AS of 0. He’s an index fund.
PM Y puts $26 each into A and B, and $24 each into C and D. His overweights total $2; the absolute value (minus signs turned into pluses) of his underweights is $2. His AS is 2%. He’s a closet indexer.
PM Z puts $30 into A $40 into B, $20 into C and $10 into D. His overweights total $20; the absolute value of his underweights is $20. His AS is 20%. He’s clearly an active manager. In the real world of asset management, he’d be regarded as very aggressive.
The Yale researchers conclude that high ASs are a good thing.