Using Active Share to Evaluate Single- and Multi-Manager Portfolios

Abstract

Active share is a statistic that describes the degree to which the holdings of an investment fund differ from the holdings of the fund’s benchmark. Practitioners and academics have produced numerous papers on active share; some portray it as a powerful metric that can be used to isolate effective active managers, whereas others highlight its imperfections and warn of its limited utility. The authors of this article evaluate how active share can be used to guide individual manager selection decisions and to assist in ongoing manager monitoring. After considering multiple perspectives, the authors assert that active share is indeed a useful statistic for evaluating investment strategies, but investors must take into account several limitations to use it appropriately. They also present a new application of active share by employing it at the asset class level. Specifically, they use active share to evaluate multimanager, US large-cap equity portfolios. The authors chose US large-cap equity because this subasset class is widely viewed as highly efficient, and it provides a particularly robust dataset for analysis. With this exercise, the authors demonstrate how investors can apply active share to help determine the optimal number of managers to include in a multimanager portfolio. The intent of the article is to help investors improve both the quality of individual manager selection decisions and the portfolio construction process for multimanager portfolios.

TOPICS: Portfolio management/multi-asset allocation, manager selection, performance measurement

Key Findings

• • In an effort to diversify the risk of adverse manager selection, institutional investors often hire multiple investment managers to fill their allocations to various asset classes. However, many investors are subsequently disappointed with the results because the benefits of diversification are often exceeded by the costs in terms of active share dilution, higher investment management fees, and greater oversight requirements.

• • Using large-cap US equity as a test case, this article demonstrates how active share can help quantify the impact of manager diversification on active management efficiency in multimanager portfolios. In addition, the article quantifies the incremental fee impact of adding investment managers to the portfolio. The results demonstrate how active share can decline rapidly after a relatively small number of managers is added to a large-cap equity portfolio. Simultaneously, both indirect and direct costs of portfolio oversight steadily and meaningfully increase with each new manager.

• • The results suggest that investors should conduct a thorough cost–benefit analysis before determining the number of investment managers to include in a multimanager portfolio. To support such endeavors, we encourage investors to quantify the incremental impact of additional managers on active share, investment management fees, and general oversight requirements. After quantifying these costs, investors can weigh them against the potential diversification benefits and identify the number of managers that provides the optimal balance.