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Aon Retirement and Investment Blog

Active Share in Equity Portfolios

Recent academic studies of US mutual fund portfolios and our previous work on Conviction in Equity Investing have shown that, on average, portfolios with high active shares outperform their benchmarks and peers over time  Active share is a part of how Aon Hewitt analyzes and constructs manager portfolios. This blog entry aims to explain what active share is and how it can be used in equity portfolio construction and manager/portfolio reviews.
What is active share?
Active share measures the percentage of a portfolio’s holdings that differ from the benchmark, i.e., the average of the sum of a portfolio’s overweight positions and the sum of its underweight positions. Active share thus gives the investor an initial indication of the share of the portfolio that is ‘active’ and working to achieve outperformance relative to a strategy's intended benchmark. Aon Hewitt, in general, prefers equity portfolios with high levels of active share (typically more than 70% for strategies with widely-diversified benchmarks). As active share declines, the remaining active share needs to perform even better to achieve the same level of outperformance and therefore the higher the level of manager skill required.
How can active share be used in portfolio construction?
When we construct a portfolio, we start with the investor’s needs and then overlay the views of our specialist teams. As part of the portfolio construction process, we include the views of our Global Asset Allocation Team, Risk & Modeling Team, and the Global Investment Management Equity Research (“GIM”) Team.
Within the GIM team, we look to construct a portfolio composed of high-conviction managers that is diversified across manager styles, investment time horizons, and other biases. We then analyze the resulting portfolio through our risk tools to ensure that it does not have any unintended risk exposures and that the largest driver of active risk (i.e., risk measured against the benchmark) is the managers’ views of individual companies (often termed 'stock selection risk') rather than a large tilt towards any style, region, sector, or type of company.
We assess the level of stock selection risk in a portfolio by examining statistical measures together with the level of active share. Although active share can provide a good indication that active risk is being taken, it does not provide an indication of the drivers of this risk. For example, consider a portfolio that is benchmarked against the MSCI World and is invested in a Global Utilities sector index fund. The active share of this hypothetical portfolio is in excess of 95% which would indicate a significant degree of active management and risk against its benchmark; however, a statistical risk model would highlight that the significant overweight to utilities stocks was almost the only risk driver and that stock selection risk was close to zero. When we examine portfolios, we ensure that both active share levels are high (greater than 70%) and that a high portion of risk is taken up by managers’ views of individual companies.

What does a high active share portfolio look like?

Portfolios with a high active share and high levels of stock selection risk will tend not to use benchmarks as a starting point for portfolio construction and have a relatively-high level of stock concentration. We term these types of portfolios 'unconstrained,' and generally prefer this active management approach.
The chart below shows the active share and tracking error (a measure of the magnitude in fluctuation of returns relative to a benchmark) of a sample of ‘unconstrained’ and traditional active managers. We then show the impact of combining ‘unconstrained’ managers and then blending this with a passive strategy to lower fees.
The chart above shows that combining ‘unconstrained’ managers significantly increases the consistency of returns (or reduces tracking error), while retaining a high active share or the portfolio’s alpha potential. Alpha is the excess return of the fund relative to the return of the benchmark index. In addition, if we combine this portfolio with a passive strategy, we can achieve a similar level of tracking error (and potentially lower fees) relative to a traditional active strategy, but with a significantly higher active share.

How can active share be used in manager and portfolio reviews?
Ensuring that managers and overall portfolios retain a high level of active share is an important part of any ongoing monitoring program. As part of our ongoing monitoring of investment strategies, the level of active risk taken is reviewed. A significant reduction in active risk can be driven by changes in the market environment, a change in the way that a portfolio is managed, or a reflection that an investment strategy is growing too large relative to its investment universe.
We focus our research on high conviction, unconstrained investment strategies as the most optimal attempt to achieve alpha within the equity universe. When we consider the combination of portfolios at the total equity asset class level, we have shown that combining a number of ‘unconstrained’ managers together with a passive strategy can result in a more efficient portfolio than a traditional active manager. We recommend that active share is regularly monitored and that at a manager and portfolio level, active risk is balanced across a number of factors with stock selection risk being the most important.

George Carvounes is a Senior Equity Researcher located in London.

The information contained above is intended for general information purposes only and should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.


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