EVALUATING MANAGER PERFORMANCE: A CLOSER LOOK AT ACTIVE SHARE

Transcription

1 EVALUATING MANAGER PERFORMANCE: A CLOSER LOOK AT ACTIVE SHARE RBC GAM Fundamental Series

2 RBC GAM Fundamental Series Evaluating Manager Performance: A Closer Look at Active Share 1 Introduction Active Share seeks to quantify a portfolio s diversity relative to an investable benchmark. Introduced in , Active Share is a weights-based measure of active portfolio management. It seeks to quantify a portfolio s diversity relative to an investable benchmark and has gained visibility and importance with institutional investors in recent years. At RBC GAM-US, we use Active Share extensively in our internal risk reporting and it is an oft-cited metric amongst some of our equity investment teams. Our experience with Active Share has led us to develop complementary metrics based on the same premise (e.g., Active Duration and Sector Active Share), but it has also provided some practical insight into the common assumptions and pitfalls practitioners should be keenly aware of when interpreting the measure. Defining Active Share Active Share is computed as follows: Active Share = ½ w portfolio i w index i Where w portfolio i and w index i are the portfolio and benchmark weights, respectively, for asset i. In words, Active Share represents the sum of the absolute values of the differences between portfolio and benchmark weights, divided by two. The common interpretation of the active share metric is that a portfolio with an Active Share of 0% is identical to its benchmark; conversely, a portfolio or fund with an Active Share of 100% is comprised exclusively of non-benchmark assets. In terms of security weights, Active Share represents the sum of the active bets a portfolio has made relative to its benchmark. Changes in Active Share imply changes in a portfolio manager s active bets, and an increasing Active Share may indicate an increase in benchmark-relative return dispersion. 1 How Active Is Your Fund Manager? A New Measure That Predicts Performance, Cremers and Petajisto, 2009.

3 2 Evaluating Manager Performance: A Closer Look at Active Share RBC GAM Fundamental Series Assumptions and Common Pitfalls Comparing Benchmarks Active Share can be a useful metric when comparing the strategy of one investment manager to another as it may assist in determining how active a manager may be. However, the metric is only relevant when the strategies being compared share the same benchmark. Recall that the Active Share calculation is not only a function of the portfolio weights it s a function of the benchmark weights as well. For example, assume Manager A and Manager B are both benchmarked against the Russell 2000 Index. It would be accurate to say that if Manager A has the higher Active Share, that Manager A s portfolio has more benchmark-relative weight diversity and may therefore be more actively positioned. However, if Manager A and Manager B have different benchmarks (regardless of the specific strategy mandate) it would be unfair to say based on Active Share alone that one manager is more actively positioned than the other. In other words, an Active Share of 80% for a strategy benchmarked against the S&P 500 Index does not necessarily imply a more actively positioned portfolio than an Active Share of 70% for a strategy benchmarked against the Russell 2000 Index. Stock Concentration Generally speaking, large cap strategies tend to be comprised of fewer and inherently more concentrated holdings than small cap strategies. Consider the large cap S&P 500 Index, which can attribute more than a quarter of its market value to just 20 constituents (Exhibit 1, next page). Compare this to the small cap Russell 2000 Index, where the same 25% share of its market value is dispersed across 130 constituents the large cap index is considerably more concentrated. Now consider two portfolios benchmarked to these indices that exhibit identical Active Share values of 75% (the first, a 20-stock large cap portfolio benchmarked to the S&P 500 Index, and the second, a 130-stock small cap portfolio benchmarked to the Russell 2000 Index). In this scenario, the largest positions in the large cap strategy would each be well over 10% of the portfolio, whereas the largest positions in the small cap strategy would each be less than 2% of the portfolio. Even though this structural distinction is significant, investors tend to apply the same security-level risk controls (e.g. a maximum single-name concentration of 2-5% of the total portfolio market value) across equity mandates regardless of where they fall on the capitalization spectrum.

4 RBC GAM Fundamental Series Evaluating Manager Performance: A Closer Look at Active Share 3 So what are the implications of this comparison? Recall from the introduction that Active Share is a weights-based measure seeking to quantify relative portfolio diversity it is a function of the number of assets in the portfolio as well as the relative weight of those assets versus the portfolio benchmark. This means that the structure of the benchmark index may predispose a given strategy to elevated (or muted) levels of Active Share. Indeed, under normal circumstances, the only way for a large cap manager to match or beat the Active Share of a small cap manager would be by taking markedly larger bets on a much smaller number of holdings. Correlated Holdings In defining active position, Active Share methodology assumes that each stock or asset difference contributes uniquely to the overall Active Share score. In other words, the weight differences between similar securities or securities in the same sector do not offset one another. Therefore, in circumstances where two or more stocks in a portfolio or benchmark are highly correlated, Active Share may overstate the active bets a manager is taking with respect to benchmark relative performance impact. There are two dominant energy companies in the S&P 500 Index: Exxon Mobil and Chevron. These large, multinational oil firms have performed similarly over time and their stock prices are highly correlated to one another (Exhibit 2). Over the past three years, their correlation, using weekly data, has been 0.83, with both stocks having a correlation to oil prices greater than 0.5. If an investment strategy benchmarked to the S&P 500 Index is overweight one of these names and underweight the other, we should expect the strategy s Active Share to increase. Exxon Mobil and Chevron are amongst the ten largest names in the index, with the sum of their weights around 4%. Consider a strategy that has a 4% weight in Chevron and no Exxon Mobil exposure. Excepting the idiosyncratic differences between the two names, this portfolio will perform quite similarly to one that has a 4% weight in Exxon Mobil and no exposure to Chevron. In other words, the manager has put on a pairs trade where factorbased exposures are largely equal (oil industry, oil price, etc.) and the only active bet is between how Chevron and Exxon will perform relative to one another. Excepting fundamental business failure, the scale of this relative performance will be much smaller than the scale of the weighting in the sector, or the sum of the weights in these two names. Active Share ignores this distinction an important caveat to consider when applying the metric is not just what a manager s Active Share is, but how the manager is generating it. EXHIBIT 1 Larger Cap Strategies Are More Concentrated Largest 20 Constituents as % of Total Index Market Value Change in Stock Price (%) S&P 500 Russell Mid Cap Russell 2000 EXHIBIT 2 Active Share May Be Overstated if Underlying Assets Are Highly Correlated Exxon Mobil (XOM) vs. Chevron (CVX), prior 3 years 30% 20% 10% 0% -10% -20% 5% 0% 5% 10% 15% 20% 25% 30% XOM US Equity CVX US Equity Sep-11 Dec-11 Mar-12 Source: Bloomberg, % Source: S&P Dow Jones Indices LLC and Russell Indexes, Jun-12 Sep-12 Dec-12 Mar-13 26% Jun-13 Sep-13 Dec-13 Mar-14 Jun-14

5 RBC GAM Fundamental Series 4 Evaluating Manager Performance: A Closer Look at Active Share Let s look at one final example using some of this data. The Active Share of a strategy benchmarked to the S&P 500 Index which invests (using market-cap-scaled weights) in the largest 50% of the benchmark s names will have an Active Share of about 50%. If rather than using the market-cap-scaled weights, a manager invested the rescaled Exxon Mobil allocation of about 5% in Chevron instead, the portfolio s Active Share would increase to about 53%. Echoing the previous argument, the Active Share has increased, yet the sector-relative weighting is identical (and the exposure to large, multinational oil companies whose stock price is highly correlated to oil prices is also identical). Now consider that the same manager took that 5% Exxon Mobil allocation and reallocated it to Apple Computer, increasing the position from 6.7% to 11.8%. The Active Share would still be 53%, but it would be difficult to argue that the portfolio with a benchmark-relative Apple position of nearly 8.5% has the same degree of active bets as the portfolio that is simply overweight Chevron. About the Author Jim Stitt Head of Data Management Jim Stitt is responsible for the oversight and implementation of the firm s enterprise-wide data management strategy. Jim has held various leadership roles within the organization, most recently as Head of Risk and Investment Performance in the United States. He has also managed professionals in business technology, policy compliance and portfolio administration. Prior to joining RBC GAM-US in 2005, he was the director of portfolio administration for a regional investment advisory and wealth management firm. Jim earned a BS from the University of CaliforniaSan Diego. Conclusion Active Share is a summary metric that can be useful in characterizing the weight-based diversity of a portfolio relative to a benchmark. In our experience, it is best applied in concert with other metrics but it can be very helpful in comparing managers using the same benchmark, as well as in monitoring how the active position of a single manager has changed over time.

6 All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. The views expressed herein reflect RBC Global Asset Management (U.S.) Inc. as of Views are subject to change at any time based on market or other conditions. RBC Global Asset Management (U.S.) Inc. ( RBC Global Asset Management - US or RBC GAM-US ) is a federally registered investment adviser founded in RBC Global Asset Management (RBC GAM) is the asset management division of Royal Bank of Canada (RBC) which includes RBC Global Asset Management (U.S.) Inc., RBC Global Asset Management Inc., RBC Global Asset Management (UK) Limited, RBC Alternative Asset Management Inc., BlueBay Asset Management LLP and BlueBay Asset Management USA LLC, which are separate, but affiliated corporate entities. / Trademark(s) of Royal Bank of Canada. Used under license RBC Global Asset Management (U.S.) Inc. RBC Global Asset Management Minneapolis Boston Chicago