Active share, a tool for demonstrating how a fund’s portfolio differs from its respective benchmark, has been a common term among active investors over the last few years. Tracking error, which has a much longer history, is often regarded as another tool that does the same job. But the differences between the two measures affect how Invesco’s Global Opportunities investment team views their effectiveness and usefulness for investors.
Tracking error: Useful from returns perspective
Tracking error — the divergence between price behaviors of a portfolio and its benchmark — is a backward looking tool, using historical data to show the volatility of the fund’s returns versus that of its benchmark. It’s useful in demonstrating how closely a portfolio follows its benchmark from a returns perspective. However, it’s important to consider these two questions:
- What’s the benchmark? A fund with a low tracking error versus a volatile benchmark may not produce the return profile investors seek.
- Are upside and downside volatility equally important to investors? The most common method of assessing tracking error involves calculating the standard deviation of the fund and benchmark returns, which reflects both upside and downside volatility. In our experience, however, investors have been more concerned about the implications of downside volatility.
More importantly, as active investors, our team’s main reservation about tracking error is acceptance of the benchmark as the right reference point for measuring volatility and, by implication, risk. In contrast, the investment world doesn’t revolve around the benchmark for our fund managers. We define risk as the potential for permanent loss of capital, using maximum drawdown and downside volatility as indicators. And we often view volatility — at least in the short term — as an opportunity to exploit valuation anomalies in the stock market.
Active share: Looks at holdings and weightings
Active share is a much simpler calculation that provides a snapshot in time. It measures how different a portfolio is from its benchmark by comparing the fund’s holdings and their weightings with those of the benchmark. We believe active share provides a clearer picture of how active a fund manager is than drawing conclusions from standard deviation calculations.
In simple terms, a tracker fund that perfectly replicates its benchmark will have an active share of 0%, while an active fund that owns no constituents of its reference benchmark will have an active share of 100%. This measure is increasingly important, given the rise of passive investing and the need to differentiate between quasi-passive and genuinely active managers.
Origin of active share
The concept of active share was introduced in research by Martijn Cremers and Antti Petajisto, which indicated that portfolios with a high active share were, on average, likely to outperform their benchmarks, suggesting a positive correlation between performance and active share.1 Additional research by Cremers and fellow economist Ankur Pareek2 combined active share analysis with portfolio managers’ stock holding period, where long duration is defined as more than two years. The research shows clear outperformance, on average, of those strategies that combine high active share and long duration, or low turnover, of stocks. Of course, past performance does not guarantee future results.
Earlier this year, Invesco published a white paper examining the historical outperformance of active management, using active share as the measuring stick for active management.
Because high active share offers no performance guarantee, it’s possible to have a high active share portfolio that underperforms its benchmark. However, our team believes that to outperform a benchmark, portfolio construction needs to differ from the benchmark, and active share is a reliable, easy way of measuring this. So while active share doesn’t guarantee performance, we believe it’s a prerequisite — if you aren’t different, then you can’t hope to achieve a different result, good or bad.
By-product of investment philosophy
While we don’t explicitly target a high active share in the Invesco Global Opportunities strategy, it’s a by-product of our investment philosophy — concentrated and flexible investing that views risk as absolute, not relative. The result is an active share that is typically high, currently at 95%.
Put simply, to create an opportunity to deliver alpha for our investors, we believe the fund has to be meaningfully different from its benchmark. In addition, we see no evidence to suggest a direct link between the strategy’s tracking error and performance.
1 Source: “How active is your fund manager? A new measure that predicts performance,” Aug. 7, 2006.
2 Source: Patient Capital Outperformance: “The Investment Skill of High Active Share Managers Who Trade Infrequently,” Sept. 19, 2014.
Alpha refers to the excess returns of a fund relative to the return of a benchmark index.
Standard deviation measures a portfolio’s range of total returns and identifies the spread of a portfolio’s short-term fluctuations.
Drawdown is the largest cumulative percentage decline in net asset value as measured on a month-end basis.
Absolute return refers to the return an asset achieves over a certain period of time, without comparison to another measure or benchmark.