How active is your fund manager?


The question of whether an active or passive investment management approach adds more value to a portfolio has long been the source of vigorous debate in the investment community.


Today’s market environment, where economic and investment trends appear to be increasingly prone to extreme fluctuations, requires a portfolio approach designed to weather difficult climates and evaluate long-term results. The debate over active and passive


investment management is more important than ever before. My colleague, Antii Petajisto (previously with the Yale School of Management and currently with BlackRock) and I introduced a new measure designed to help investors judge the merits of active and passive management. We titled this measure “Active Share,” and it represents a way to measure the share of portfolio holdings that differs from the benchmark index holdings.


By K. J. Martijn Cremers, International Center for Finance, Yale School of Management


Active and passive defined Passive portfolio management is fairly simple to define. It consists of replicating the return of an index with a strategy that buys and holds all – or almost all – stocks in the index in the same official index proportions. Active portfolio management then can simplistically be defined as any deviation from passive management. Active investing entails the deployment of strategies designed to maximize returns with the aim of outperforming the broad market’s results as measured by a particular index or benchmark. An actively managed portfolio relies on experienced fund managers or teams of investment professionals conducting research on economic and market conditions, which in turn helps guide their investment decisions. An actively managed fund can differ


This material contains the opinions of the featured investment professional, but not necessarily those of Aberdeen Asset Management Inc., and such opinions are subject to change without notice.


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from the benchmark holdings in two general ways: either because of stock selection or factor timing—or both. Stock selection involves picking individual stocks that the fund manager expects to outperform their peers. Factor timing involves time-


varying selections based on an evaluation of systematic risk factors such as entire industries, sectors of the economy or other factors.


Measuring active management In the past, measuring how actively a portfolio is managed was typically done by calculating a portfolio’s tracking error, which is a measure of how much the return on a portfolio deviates from the return on its benchmark index. Tracking error represents the volatility of the difference between a portfolio return and its benchmark index return. On the other hand, there are different


approaches to active portfolio management and this is where the difficulties arise: how to measure the deviation depends on what aspect of active management is used. For this reason, simply using tracking error to measure active management left something to be desired. For example, some actively managed


funds may be driven by pure stock selection to generate alpha within particular sectors or industries. Other funds may be managed as “sector rotators” and focus on actively picking entire sectors or industries that the portfolio managers believe will outperform the broader market while holding mostly diversified positions within those sectors. The tracking error of the “stock picker” is substantially lower than that of the “sector rotator,” suggesting that the former is much less active. But this would be an incorrect assumption; the tracking error of the stock picker is lower simply because individual stock selections help permit greater diversification, even while potentially contributing to positive alpha. This is the reason a new measure


of active portfolio management became necessary.


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