There are two chief ways of measuring a portfolio’s deviation from its benchmark: tracking error and active share. The first, tracking error, is the older and more traditional. It gauges a portfolio’s performance deviation from a benchmark return over time – essentially telling an investor how different the returns are from the benchmark. The second, active share, is newer but steadily gaining steam. It specifically measures how unique a portfolio is, at the holdings level, relative to the benchmark.
Tracking Error vs Active Share
Of the two, which is best? That’s the question MFS Fixed Income Portfolio Manager David Cole, Chief Risk Officer Joseph Flaherty, and Quantitative Research Analyst Sean Cameron set out to answer in an October 2015 white paper Active Share: A valuable risk measure for high-yield portfolios. As evident from the title, the trio values active share – but not exclusively. While active share can be an alternative to tracking error, one can complement the other, particularly in measuring the relative risk of a high-yield bond portfolio, which is the subject of the paper. Their findings:
- Active managers are increasingly being asked to demonstrate just how active they really are. Active share is the best measure for making this determination, since it looks at portfolios on the holdings level, whereas tracking error merely shows deviation of performance.
- Both can be useful, but tracking error is more a proxy for “systematic factor exposure,” whereas active share provides “valuable information on the degree of conviction,” according to the paper’s authors.
As stated earlier, active share and tracking error can be used together, and this is especially useful in classifying high-yield bond portfolio managers. Using both measures allows investors to gauge a manager’s “activeness” and determine the sources of that activeness. According to the authors, “relatively high active share in combination with relatively low tracking error would be consistent with an active, diversified, high-yield credit manager.”
Active share has typically been used in evaluating equity portfolios, but Cole, Flaherty, and Cameron show its usefulness—sometimes in conjunction with tracking error—in assessing high-yield bond portfolios, too. Active share in particular can give investors insight into the drivers of risk and return in credit-oriented fixed-income portfolios, which may have low tracking error but are actually quite active. “This,” according to the authors, “is consistent with a high-yield manager’s investment process, which frequently entails minimizing systematic risk while seeking to maximize returns from the security selection process.”