The Many Shades of Active Share
The correlation of stock returns has declined to multi-year lows (Figure 1). This should be good news for active managers trying to differentiate themselves from passive indexes, but some are struggling to do so.
Figure 1 – The Correlation of Stock Returns Has Dropped to Multi-Year Lows
Note: Six month intra-portfolio correlations for Russell 1000 constituents. Source: Cornerstone Capital Management and Bloomberg LLP.
“There are many shades of active share” ranging from indexers to closet indexers to concentrated portfolios and beyond, says Andrew Ver Planck, Chief Investment Officer and Lead Portfolio Manager of Global Systematic Equity at Cornerstone Capital Management which advises multiple funds for MainStay Investments. All else being equal, strategies with high active shares have been able to charge higher fees (Figure 2). As of December 31, active managers reporting a 90% or higher active share in the eVestment U.S Large Cap Core universe charged an average of 77 basis points, while those reporting 60% or less active shares charged 46 basis points.
Figure 2 – Active Share Ranges in eVestment U.S. Large Cap Universe
Note: Based on 162 managers reporting their active shares. Average fees based on a $100M portfolio. Source: Cornerstone Capital Management and eVestment.
Different Ways to Create Active Share
There are different ways one can go about creating active share:
- Own stocks that are not in one’s benchmark
- Weight benchmark constituents differently
- Own American Depositary Receipts (ADRs) rather than traditional shares
- Own non-benchmark constituents with a high correlations to benchmark constituents
- Short shares, utilize leverage1, or combine both
Correlations Are Just One Piece in the Puzzle
Low correlations mean stock specific risk should have a relatively larger influence on returns, while macro factors have proportionately less. Ver Planck and his colleagues welcome low stock correlations, especially in a low volatility environment which tends to mute top-down influences on portfolio returns; allowing their bottom-up process focused on stock selection to be a more prominent driver of alpha. By the same token, in a high volatility environment, stock correlations aside, if a manager doesn’t have adequate risk controls in place, macro influences may dominate a bottom-up manager’s return profile and potentially increase benchmark relative risk, known as tracking error, for the wrong reasons.
Ver Planck and his colleagues deploy robust risk controls at the sector/industry, market capitalization, beta, and security levels to limit macro influences. Their portfolios focus on stock selection. They use an Active Extension structure to express the full range of their views, incorporating both long and short stock positions, resulting in greater active share than would otherwise be the case. Why do this?
Fundamental Law of Active Management
It relates to the fundamental law of active management by Grinald and Kahn according to Ver Planck. The fundamental law equates the productivity of an active manager (IR) by its level of skill (IC) and how often that skill is put to use (Breadth) in the formula: IR = IC * sqrt (Breath). The team uses quantitative factors such as value, sentiment, and momentum to generate IC and an active extension structure with small active weights to generate Breadth which is measured as the number of independent bets in the fundamental law.
Correlations and Factors
Ver Planck and his team believe the recent drop in stock correlations shown above is owed, in part, to November’s election outcome and the policy implications that stemmed from it, including the potential disparity between winners and losers from possible tax reform, health care changes, and infrastructure spending. Monetary tightening, a healthy M&A backdrop, and a return to profit growth have also shaped the current environment.
At the factor level, sentiment had a strong first quarter while momentum signals are starting to stabilize, notably on the short side, after a difficult 2016. Value performed well heading into and following the election but stalled more recently. Ver Planck prefers a multi-factor approach because the opportunity set is always shifting and no single factor works best all the time.
Stock correlations have declined to their lowest level in years but some active managers are still struggling to differentiate themselves from passive indices. There are several ways to create active share and strong risk controls can improve a portfolio’s focus on stocks.
1. Short positions pose a risk because they lose value as a security’s price increases; therefore, the loss on a short sale is theoretically unlimited. As a result, these funds may not be suitable for all investors. The use of leverage may increase the Fund’s exposure to long equity positions and make any change in the Fund’s NAV greater than it would be without the use of leverage. This could result in increased volatility of returns.
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All investments are subject to market risk, including possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market.
Large cap (sometimes “big cap”) refers to a company with a market capitalization value of more than $5 billion. Large cap is a shortened version of the term “large market capitalization.” Market capitalization is calculated by multiplying the number of a company’s shares outstanding by its stock price per share. The dollar amounts used for the classifications “large cap,” mid cap” or “small cap” are only approximations that change over time.
Active Share is a method of determining the extent of active management employed by an investment manager and a significant tool for helping investors find those active managers that do outperform their benchmarks. The higher the active share, the greater the extent of active management employed.
Active management is an investment strategy involving ongoing buying and selling actions by the manager. Active managers purchase investments and continuously monitor their activity in order to exploit profitable conditions. Active management typically charges higher fees than passive management.
Correlation is a statistic that measures the degree to which two securities move in relation to each other.
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
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