The performance suggests that investors should consider managers that are unconstrained by a benchmark. This creates another challenge – how do you know a manager is truly active?
The importance of active share
While there are a lot of different metrics that can be run to analyze an equity manager’s portfolio and performance, active share is likely the best objective measure of how active a manager is. The definition and calculation of active share are relatively simple: It is the percentage of a portfolio – considering actual portfolio holdings and weightings – that differs from its benchmark.
There are only four ways a portfolio can differ from the benchmark (see Figure 6):
- Own a benchmark company at an underweight (A)
- Own a benchmark company at an overweight (B)
- Do not own a benchmark company (C)
- Own a company not in the benchmark (D)
To calculate active share, you take the absolute value of the difference between portfolio holding and benchmark weights, sum all of these differences, and divide by two (to account for overweights and underweights). You will get an active share number between 0%, which indicates the portfolio perfectly replicates the benchmark, and 100%, which tells you that there is no overlap whatsoever between the portfolio and the index. A manager needs an active share of at least 60% to be considered active, with 80% active share defining “highly active” managers referenced earlier. (see “How Active is Your Manager? A New Measure that Predicts Performance,” by Martijin Cremers and Antti Petajisto of the International Center for Finance at the Yale School of Management, January 2007).
Let’s walk through an illustration of why active share is important. In this example, we have two hypothetical managers, one with 50% active share and one with 80% active share. We assume a benchmark return of 10%, manager fees of 100 basis points (bps, there are 100 basis points in 1%), and a net excess return target of 200 bps.
For the 50% active share manager, since half of the portfolio overlaps with the benchmark, that portion of the portfolio returns 10%, in line with the benchmark. This means that in order to hit the excess return target, the active portion of the portfolio has to work really hard and outperform by 600 bps (see Figure 7).
For the manager with 80% active share, we’ll assume the 20% of his portfolio that overlaps with the benchmark also delivers the benchmark return of 10%, which means that the active portion of the portfolio has to outperform by 375 bps to achieve the overall target excess return. Of course, 375 bps of outperformance is not easy – but it is 225 bps easier than 600 bps!
High active share, then, not only provides the potential for higher returns, but it increases the probability of achieving excess returns. Of course, high active share also leads to a greater opportunity to underperform the benchmark, so manager selection is key. We believe high active share should be top of mind when selecting active equity managers.
Evolving equity portfolio structures
Moving away from the style box raises the question: how should equity portfolios be structured? We see two solutions.
Core/satellite:
If the style box construct has morphed into an expensive index strategy, then core/satellite addresses that problem by going passive at the core to obtain beta exposure more cheaply, particularly in more efficient markets. Active strategies with high alpha potential could then be added to complement this passive core. Satellite strategies typically include managers that are highly active, unconstrained, high-conviction and outcome-oriented, or in asset classes deemed less efficient, such as emerging markets.
Global unconstrained:
The key change in this structure vs. the style box is that an investor would no longer make the distinction between domestic managers and international managers, and instead would hire several (for manager diversification) global, unconstrained managers. These global equity mandates would likely be complemented by allocations to active emerging markets. In addition, here global managers would be measured against broader benchmarks, such as MSCI World or ACWI. While managers still may have a style-oriented investment strategy – i.e., be value or growth investors – they will be held accountable to a broader benchmark and adhere to their discipline because they believe that discipline (investment process, research views) will allow them to outperform the broad market, not because they are playing a narrow, style-constrained role in a portfolio.
Restructuring an equity portfolio can be challenging. Part of the allure of the style-box approach is the feeling of control over equity allocations and exposures. Moving away from that comforting approach and toward unconstrained shifts some of that control to the managers. In addition, while high active share provides the potential for higher returns, it also creates the risk of significant underperformance. Because of this, our belief is that outside of the style box, manager selection and manager diversification become even more important. There must be in-depth due diligence on each manager’s investment philosophy, team, investment criteria and process to gain a clear understanding of how the manager may perform in various market environments and how they may complement other managers. Managers must demonstrate a research quality that allows them the potential to transform high active share into strong performance. We believe this combination of broader benchmarks and deeper due diligence will result in a better understanding of manager performance over shorter-term cycles, ultimately leading to longer investment time horizons and better returns.
At PIMCO, our active equity strategies are positioned for this evolving equity landscape. All of our strategies are global, unconstrained by the benchmark (seeking at least 80% active share), and consider downside risk mitigation as a critical part of the client experience. As investors move away from the style box quickly or more gradually, we will be there with equity solutions to help meet investor needs.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their financial advisor prior to making an investment decision.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
Copyright © 2012, PIMCO
