Advisors and their clients are increasingly seeking alpha, especially as the forecasted market rate of return continues to slide into the low single digits. It’s impossible to achieve alpha without active share – but to what extent does portfolio concentration and active share impact a portfolio’s performance? In a new whitepaper titled Active Share and Private Pair Analysis, Callan President and Director of Research Greg Allen examines this question and shares his firm’s findings.
Yale researchers Antti Petajisto and Martijn Cremers shook up the world of finance when they published their 2007 paper introducing the concept of “active share.” Put simply, a portfolio’s “active share” is the degree to which its holdings differ from those of its benchmark – a portfolio consisting of 500 stocks in exact proportions to their holdings within the S&P 500 index would have 0% active share; while a portfolio with none of the same holdings as the S&P 500 would have 100% active share.
Petajisto and Cremers’ paper found that funds with the highest active share outperformed their benchmarks by 1%, net of fees; while funds with the lowest active share underperformed their benchmarks. In a new whitepaper published this month, Callan President and Director of Research Greg Allen examines the implications of these findings and takes a deeper look at the concept of “active share” by viewing funds in “product pairs.”
In an attempt to expand upon the work of Petajisto and Cremers, Mr. Allen uses “product pairs,” which are portfolios managed by the same team or individual, with the same basic investment philosophy and research platform, and measured against the same benchmark – but with different degrees of portfolio concentration, and different levels of active share. Thus, the impact of active share can be measured in isolation of other “exogenous” factors.
Callan’s analysis considered the period between December 31, 1989 and December 31, 2013. Only a handful of funds had track records that span the entire period. It is hypothesized that some funds didn’t make their data available due to “relatively poor performance” or presumption of lack of institutional interest. For this reason, Mr. Allen admits that the study suffers from some degree of self-selection bias.
Concentrated vs. Diversified Portfolios
Nevertheless, by comparing concentrated (high active share) and diversified (lower active share) versions of the same strategy managed by the same people, Callan found that concentrated portfolios outperformed across a variety of statistical measures. All concentrated and diversified portfolios in the study averaged returns in excess of the risk-free rate of return in terms of both mean and median, but concentrated portfolios outperformed across the board. While the mean excess return of a diversified portfolio was 0.39, the mean excess return of a concentrated portfolio was 0.6; and while the median excess return of a diversified portfolio was 0.18, the median excess return of a concentrated portfolio was 0.22.
Mr. Allen notes that the self-selection bias may be on display here, as the funds in the study generated positive excess returns on average, while this is not typically the case of the entire universe of funds. It’s also important to note that the outperformance of the concentrated portfolios – with greater active share – occurred during a period of general outperformance; and thus, the positive relationship between active share and performance may not hold during bear markets.
In the presence of managerial skill, active share is a good thing. In the absence of skill, however, it can be a detriment. Callan’s whitepaper concludes by noting the importance of portfolio concentration and managerial conviction, but holds that it accounts for “less than 5% of the total picture.” Survivorship bias – the fact that defunct funds weren’t included in the original Petajisto and Cremers study, nor in Callan’s – “could easily explain the results” of both, according to Mr. Allen.
For more information, download a pdf copy of the whitepaper.