Active Share - Clarification


I was recently reading the white paper “How Active Is Your Fund Manager? A New Measure That Predicts Performance” on active share by Cremers and Patijisto.

I was wondeing if someone could help me understand the meaning of the following passage:

“The main conceptual difference between Active Share and tracking error is that tracking error includes the covariance matrix of returns. As a result, tracking error puts signicantly more weight on correlated active bets in other words, bets on systematic factors. This makes tracking error a reasonable proxy for factor timing.” How does it mean by tracking error includes the covariance matrix of returns? How does it put more weight on correlated active bets? Thanks

Active share is definitely the term of the year in the mutual fund industry. I’m very familiar with that white paper. Even though it’s from 2009 it really just caught on this year. Subsequent white papers have completely debunked the active share myth. First my soapbox, then I’ll address your question.

Active share doesn’t measure manager skill (alpha) at all. All active share does is add up the differences of a manager’s over/underweights relative to a benchmark. It’s a very simple metric that really doesn’t tell you much. Tracking error is the stardard deviation of a portfolio’s excess returns and, hence, deals with covariance of returns.

Active share is holdings based, tracking error is returns based. Neither metric tells you anything about a manager’s ability to produce alpha. Taken together you can see how active a manager is versus their benchmark, but not whether those bets are paying off, or - more importantly - if they’ll pay off in the future.

Anyway, to answer your question, tracking error puts more weight on factor bets (or correlated active bets) than tracking error. If a manager takes a huge bet on financials they’ll have high tracking error and their returns will be dependent on how their bet pays off. If they underweight another sector, say IT, and index the rest of the portfolio they’ll have a very low active share and high tracking error.

You can label a manager based on tracking error and active share thusly:

Low TE and AS = Closet Indexing

Low TE and High AS = Diversified Stock Picks

High TE and High AS = Concentrated Stock Picks

High TE and Low AS = Factor Bets

For the last 18 months all anyone has wanted is the high tracking error, high active share portfolios. Five years into a bull market they look pretty good. We’ll see what happens when the market corrects itself.