» Active Share PRACTICAL STOCK INVESTING

As I wrote yesterday, Active Share (AS) is a way to measure the portion of a portfolio that deviates from its benchmark index. It’s arrived at by adding up all a portfolio’s underweights and overweights, dividing by two and expressing the result as a percentage of assets. AS can range from 0%, which means the portfolio exactly replicates its benchmark index (i.e., is an index fund), to 100%, meaning the portfolio holds nothing that’s in its benchmark.

what’s good about AS

I’ve always used it as a measure of the riskiness of my portfolio.

If I had four potential outperforming stocks that I thought would carry my portfolio for the current year or more, and the same number of underweights that I had similar conviction in

and if I established, say, a 1.5% difference from the index with each of the eight positions,

and if I thought that my good stocks could outperform the index by 20%, and the bad ones underperform by the same amount,

then I could earn outperformance of 20 percentage points on the 12% of the portfolio that differed from the benchmark. That’s the same as outperformance of 2.4% for the portfolio as a whole, assuming that everything went according to plan. (That rarely happens, of course. Things are either a lot better–or a lot worse.)

+/- symmetry

If we assume the world is symmetrical and that I would lose 20% on any position that went against me (this is a wildly arbitrary assumption), then the worst that could happen (I’m shuddering as I type this) is that the portfolio would underperform by 2.4%.

performance vs. expectations

Okay, I now know something about the risk character of my portfolio. As a money manager, I also have to ask how this corresponds with the needs and expectations of my clients.

During the mid-1980s, I worked for a couple of years for TIAA, managing money in Pacific Basin stock markets. In the international area, our performance bonuses maxed out with outperformance of 1% above our benchmarks. We would receive a small payment for keeping pace with the benchmark. Even that disappeared entirely, however, if yearly performance fell more than 0.25% below the index.

This is an example, in my mind, of severe risk aversion. The bonus guidelines told me: nice if you can get some outperformance, but never, ever, fall below the index. Arguably, this is closet indexing.

In contrast, I subsequently worked at a firm that for a (mercifully, short) time had a compensation schedule that set the risk bar at +/- 60o basis points vs. the benchmark. To my mind, this encouraged managers to take crazy high, risk-the-franchise levels of risk. More below.

what’s bad about AS

summarizing the good

AS gives a vocabulary for discussing how much a portfolio deviates from its index. It implictly introduces the idea that portfolio risk consists in such deviation, which I think is correct.

We can also say that there’s something wrong with a $10 billion fund that collects $100 million in management fees yearly for active management, while maintaining an AS that’s at or close to 0.

the bad

On the other hand, there’s a temptation to think that because an AS of 0 for an active manager is bad, that, while an AS of 10% might be good, one of 50% must be even better.

I think that’s wrong, in two ways:

–to get an AS above, say, 30%, a manager has to have deep knowledge and conviction about at least 15 or 20 things. (One could, in theory, get to that level by making one gigantic stock bet, but regulations and contracts most likely rule out that option.) I know I could never have been the smart money on so many topics. I’ve never encountered anyone who could.

Better to be a yard wide and a mile deep than the opposite.

In other words, at some point, I would think, high AS becomes a warning sign that a manager has lost control of his portfolio. That’s not a positive.

–if an AS of 2% is a Fourth of July sparkler, an AS of 30% is a ton of nitroglycerine. If all the bets go wrong, the result will be a loss of, say, 12% vs. the index in a year. No matter what they say up front, this is not what clients expect. They’ll leave in droves.

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.

Active Share

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.

An example:

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.

More tomorrow.