Equity Allocations: Thinking Outside of the Box

by Ryan Larson, Research Affiliates, LLC

In a classic puzzle, readers are asked to draw four straight lines through a 3 �– 3 matrix of nine dots—without letting their pencils leave the paper (see Figure 1). Most readers fail, at least initially, ending up with one dot left over. The solution requires thinking outside the box. The phrase “thinking outside of the box” has become so overused in recent years as to become trite. And yet, how many investors actually deviate from the norm with their equity allocations? Indeed, most investors follow the pack, implementing one of three “standard” strategies.

In this issue we will look at a different way of constructing the equity portfolio. We will use the concept of “active share”—a measure of how much active equity portfolios actually deviate from their benchmark indexes—as well as what active share tells us about the standard equity structure alternatives.

Equity Structure Choices The success of an investor’s overall portfolio is highly dependent on how well the equity component performs; stocks are the largest allocation in most portfolios, on average half of assets or more.¹ Therefore, paying special attention to the equity strategy decision is very important.

The three common ways to structure stock portfolios are:

1. 100% passive management, tracking a cap-weighted index

2. 100% active management, usually fundamental stockpicking strategies

3. Core-satellite—a combination of passive indexing and active management

An equity structure that entirely uses a passive cap-weighted index approach provides the market return less implementation costs. This equity structure gives you low cost and little shortfall risk relative to the benchmark, but no potential for added value, otherwise known as “alpha.” Without any alpha the passive equity structure locks in future stock returns that are unlikely to meet an investor’s return goals.²

To beat the market, investor portfolios must be different than the market. So, an investor who wants or needs to beat the market must populate his or her portfolio with active strategies because of the bets they take away from the benchmark. But exactly how active are active managers? In 2006, Martijn Cremers and Antti Petajisto of Yale University introduced a tool—dubbed “active share”—to measure how much active managers differ from the benchmark index.³

The active share measurement ranges from 0% for an index-tracking portfolio, such as an S&P 500 fund, to 100% for a fund that holds no overlap with the index, such as a concentrated active stock-picking strategy. Most active managers lie somewhere in between.⁴

Cremers and Petajisto found that funds in the highest active share quintile achieved the largest average alpha—1.1% per year net of fees and transaction costs.⁵

The average active share of this quintile of active managers is approximately 90%— that is, the typical portfolio had only a 10% overlap with the index. For the active management industry as a whole, the authors found that active share was just 30% and that the average fund returned –0.43% against the market. Net net, investors frequently end up paying high active management fees for index-like returns (or worse)!

Clearly, alpha-seeking investors should invest only in the managers with the highest active share, where they get the most compensation for taking active management risk. But the catch is that top quintile active share managers suffer from large tracking error—a statistical measure of volatility of excess returns versus the benchmark.

Although an excess return of 1.1% is attractive, studies show that both institutional and retail investors don’t have the stomach to sit through bouts of underperformance inherent in high tracking error strategies.⁶

As a result, retail investors (imitating their institutional cousins) are increasingly shifting assets into low-cost passive index funds, which have grown from 5% of equity mutual fund assets in 1996 to 15% in 2010.⁷