Active Portfolio or Incompatible Benchmark?

3 ways active share can help managers demonstrate the difference

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prove that your high active share comes from skill and not a poorly chosen benchmark

As an active manager, you know that statistics like active share can help you quantify just how active your portfolio is. An active share of at least 60% versus your benchmark is good, and an active share in excess of 70, 80 or 90% is even better, depending on your mandate.

So what do you say to a client or consultant when they want you to prove that your high active share stats reflect your active investment skill instead of just a poorly chosen benchmark?

Fortunately, there are several ways to test a portfolio for benchmark compatibility and its slippery cousin, style consistency. Here are three types of active share analysis that should give you all the ammunition you need to defend your active skill and your primary benchmark:

1. Portfolio Active Share vs. Multiple Indices: Point in Time

This analysis looks at how a portfolio stacks up against the holdings of its primary performance benchmark as well as the holdings of alternate benchmarks.

The idea is that a portfolio should have more in common with an appropriate benchmark index than it does with an incompatible one. You would expect that a small-cap growth portfolio’s active share would be lowest against the Russell 2000 Growth Index, since it has the most overlap with that index. Conversely, its active share should be higher against less-appropriate benchmarks like the Russell 2000 or the Russell Mid-Cap. By running an active share analysis against multiple indices, a manager can demonstrate that their primary benchmark is, indeed, the most appropriate proxy for their mandate.

Portfolio active share compared to multiple indices

Let’s look at an example of how this analysis plays out in real life. We’ll assume the manager in question is running an active small-cap growth portfolio. Their primary benchmark is the Russell 2000 Growth Index — index 1 — in the chart above. Index 2 is the Russell 2000; index 3 is the Russell Mid-Cap Index; and index 4 is the Russell 2000 Value Index.

The portfolio has a very high active share of 93.3% versus their primary benchmark. Their active share against the other three indices gets progressively higher—indicating that the portfolio has more in common with the Russell 2000 Growth Index it does with the Small-Cap, Mid-Cap or Small-Cap Value index. So far, so good for our small-cap growth manager. They have point-in-time evidence that a) their portfolio reflects a small-cap growth bias and b) the Russell 2000 Growth Index is an appropriate performance proxy for this portfolio.

2. Portfolio Active Share vs. Multiple Indices: Time Series

Portfolio active share over time compared to multiple indices

As the graph above illustrates, things get even more interesting when you look at active share against various benchmarks over time. Time series analysis can reveal patterns of portfolio behavior. Portfolios that consistently demonstrate the lowest active share versus their primary benchmark are likely dedicated to their mandate and managed through a disciplined investment philosophy and process—an important consideration in manager selection and retention.

The thick blue line denotes this portfolio’s primary benchmark index, index 1. As you can see, this hasn’t been the one with the lowest active share in the past, but the portfolio has recently begun to align with its primary benchmark. Is this the best benchmark for this portfolio? Did the manager change style or let the portfolio drift? Is there something else at work here?

Perhaps the portfolio’s strategic mandate changed during the period covered by the chart, or reallocations of cash into or out of the portfolio temporarily disrupted the manager’s investment discipline. Both could explain the early periods of misalignment with the primary benchmark. Structural changes to the composition of the benchmark index can also create misalignments, although these tend to be shorter-term anomalies and smooth out over time.

Of course, perhaps the portfolio simply has a history of style drift. No matter what the rationale in the example above, having access to this type of historical active share information against multiple benchmarks allows you to engage in a meaningful discussion with your clients and their consultants about how exogenous factors affect the portfolio, the discipline of your investment process and your commitment to your mandate.

3. Active Share vs. Style Indices: Consistency over Time

This analysis lets you use active share/multiple indices analysis in a slightly different way, one suggested in the original research by Profs. Martijn Cremers and Antti Petajisto: Tracking the style of a portfolio over time.

Style consistency over time based on active share

Based on a specified set of color-coded indices, the chart above identifies the index with the lowest active share at the end of each time interval. The portfolio is determined to “belong” to the style represented by the index with the lowest active share. If the color remains the same across all intervals, it indicates the portfolio has been consistent in its style and/or investment approach.

As an example, let’s say you have a small-cap growth manager whose primary benchmark is the Russell 2000 Growth index. For the purposes of this chart, you specify the following indices and colors:

R2000 Growth Small-Cap Growth Pink
R2000 Small-Cap Green
R2000 Value Small-Cap Value Gray
Russell Mid-cap Mid-Cap Blue

The portfolio has had the lowest active share to the Russell 2000 Growth index in all but two periods displayed in the chart. Those intervals may be anomalies, or due to index reconstitution, or perhaps they signal a change in the manager’s investment approach. Overall, it appears that the primary benchmark has been appropriate for this portfolio.

But there is more to be gleaned here. Using the indices as a proxy for style, this portfolio has been remarkably consistent in its adherence to their small-cap growth mandate. Even when its active share trended toward the Russell 2000, it was still a small-cap portfolio, albeit one with a less pronounced growth tilt—something that could be explained by a change in the composition of the indices themselves. Not only does the Russell 2000 Growth index appear to be an appropriate benchmark for this portfolio, but the manager has also been consistent in sticking to their assigned mandate over the period of the analysis.

Armed with these active share analytics, managers can now show clients and consultants just how appropriate their portfolio’s benchmark is, what the alternatives look like and how their investment process ensures consistency of style adherence over time.

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