abrdn Asia Focus: should you care about active share?

Passive investing was first made available to a retail audience almost half a century ago. The year was 1976, and the strategy that blazed the trail was the suitably named First Index Investment Trust.

This momentous event rather passed me by, as I had yet to enter the world of fund management at that point. In fact, I had yet to enter the world – full stop. I was still, as they say, a twinkle in my father’s eye.

Fast-forward to the present day and we find passive investing’s popularity still rising. Many investors favour funds whose constituents are automatically selected to match a specific index or market segment.

For other investors, though, merely being the market is a poor second to beating the market. It is the job of active managers such as myself to accomplish the latter goal through diligent stock-picking and portfolio construction.

Clients pay extra fees for this service, which is why they are likely to feel annoyed – if not downright deceived – when an actively managed fund conspicuously mirrors its benchmark index. This brings us to a concept known as active share.

Conceived by two finance professors at Yale University, active share is a measure used to assess the level of active management in a portfolio. In effect, it offers a means of determining the extent to which a fund’s holdings differ from those of its benchmark.

A pure index fund – that is, an entirely passive fund – has an active share of 0%. At the other extreme of the scale, a fund that has no overlap whatsoever with its benchmark has an active share of 100%.

Our own fund has an active share of around 97%, which is notably high for an Asia-focused strategy. So why is it so far removed from its underlying index? Much of the explanation lies in the myriad attractions of the region’s smaller companies.

Beyond replication

A key aim of active share is to identify actively managed funds that are “closet indexers”. The originators of the idea broadly defined such funds as having an active share of between 20% and 60%, with anything lower than 20% qualifying as a passive vehicle.

The 2006 study that introduced active share surveyed the holdings of US equity funds over a period of more than two decades. It concluded around a third could be categorised as closet indexers.

The research found funds with high active share tended to “significantly” outperform their benchmarks before and after expenses. It also reported that they had “strong performance persistence”¹

Several studies have since highlighted the underperformance of some high-active-share funds². The fact is that numerous dynamics can be at play, and it is right to reiterate that a passive approach might be preferable for many investors.

Yet what cannot be denied is that a fund must deviate from its index to have any chance of outperforming it. Although success is by no means guaranteed, active share is necessary to move beyond mere replication.

Our closest benchmark for abrdn Asia Focus plc is the MSCI AC Asia ex Japan Small Cap Index. It is comprised of more than 1,700 stocks, which gives us good scope for venturing off the beaten path.

By way of illustration, compare the top 10 holdings in the index and the top 10 holdings in our fund at the end of July this year. Not a single stock featured in both lists. In addition, our top 10 represented only 0.5% of the benchmark but more than 30% of our portfolio.

Country allocations also varied considerably. For example, Indonesia accounted for just 1.9% of the index’s constituents and 9.3% of the trust’s, while Vietnam accounted for 0% and 6.9% respectively. 
 

Insight as an engine of differentiation

So are we being deliberately contrarian? Are we just “gaming the system” to avoid the stigma of being branded a closet indexer? Exactly why do we differ from our benchmark to such a degree?

The answer is that our investment decisions are the products of our own research and engagement. They reflect our grasp of the opportunities that exist within some of the world’s most exciting economies.

Despite outperforming their large-cap counterparts for a number of years, Asian smaller companies are routinely overlooked by many investors. Crucially, they are also routinely overlooked by most investment analysts.

As a result, specialist investment teams with an on-the-ground presence can possess a valuable advantage. They should have an edge in seeking out promising businesses whose long-term potential is widely unappreciated.

This is why our principal holdings rarely align with those of the index. It is why there are likely to be disparities in portfolio construction from top to bottom.

It is also why we see so much promise in the smaller companies of countries such as Indonesia and Vietnam. These nations’ capacity for economic growth is generally recognised, but the role of their small-cap and mid-cap businesses in driving innovation is far less acknowledged.

It is important to stress for a final time that high active share does not invariably translate into enhanced returns. There is always a risk that major departures from a benchmark could be to a portfolio’s detriment.

That said, a high active share is likely to merit investors’ attention if it is accompanied by outperformance over time. Not least in the most under-researched corners of the investment universe, it might just indicate a level of insight that could make a difference in more ways than one.

Gabriel Sacks is Co-Manager of abrdn Asia Focus plc.