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SPONSORED PROFILE: The science of investing

Elstom_AberdeenWithin active management, being different leads to improved performance. Aberdeen Asset Management is a firm advocate of this practice and research is proving the firm right.

Science is proving that in the world of active asset management, being different leads to better performance and those managers that most differ from their benchmarks are coming out on top.

Active Share is a measure of active portfolio management devised by Yale professors Martijn Cremers and Antti Petajisto that represents the share of portfolio holdings that differ from the benchmark index holdings.

They say that Active Share can be easily interpreted as the “fraction of the portfolio that is different from the benchmark index.”

Although the idea of looking at managers and how they invest in relation to their benchmark is not new, this concept had previously not been linked to performance.

However, Cremers and Petajisto found that: “Active Share predicts fund performance. Funds with the highest active share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence. Non-index funds with the lowest active share underperform their benchmarks.”

This measure of active management has given independent investment house Aberdeen Asset Management an even stronger grounding in its process.

The firm has always believed in being different and this research is finding this conviction to be even more valuable.
Aberdeen Asset Management strategist Peter Elston, says: “Successful investing is all about being different. The minute you start trying to copy other people or start following the herd, you start to produce sub-optimal or poor performance.

“We pride ourselves on being very high-conviction managers and on being prepared to ignore benchmarks and take positions that are very different to the benchmark.”

Cremers and Petajisto say the main advantage of their methodology is that it allows one to distinguish between different types of active funds. It also helps market observers focus on the funds and the managers ones that are truly active, as opposed to those who just claim they to be.

Elston says: “Many active managers out there are benchmark huggers and closet indexers. But our funds on the whole look very different to the benchmark.

“The link between a high active share and better performance is very strong. It’s an interesting finding. It’s also very supportive of what we do at Aberdeen. The active share of our funds is quite high and this research helps put some science behind what we do.”

Unique process
There are plenty of misconceptions about active management. Many have talked about the idea of what portion of performance is down to luck and what can be attributed to fund manager skill, and what each decision contributes to a fund’s final performance.

Elston says: “We try to assess where we think businesses are going to be in ten years’ time and there’s a certain element of skill in that. We don’t get it right all the time, but we get it right more than we get it wrong.”

And this long-term horizon also defines the way Aberdeen considers risk.

Although many consider risk to be related to volatility, Aberdeen AM is of a different opinion.

Elston says: “We would argue that stocks going up and down is not risk. We think that risk that needs to be considered relates to companies going bankrupt. It’s about the distinction between permanent loss of capital and a temporary loss of capital, which is associated with volatility.

“Most of the time when the share price of an equity goes down, it’s going to go up again. Only on a small number of occasions does a share price going down mean that the company will go bust, and that is what we consider to be the most important risk.”

He says the only thing the firm can promise clients is that its funds will underperform from time to time.

Tracking error
In their research, Yale professors Cremers and Petajisto also made a link between tracking error and active share. 
They say that active share, used in conjunction with tracking error can give a more comprehensive picture of active management, allowing us to distinguish between stock selection and factor timing.

“The main conceptual difference between the measures is that tracking error incorporates the co-variance matrix of returns and this puts significantly more weight on correlated active bets, whereas Active Share puts equal weight on all active bets regardless of diversification. Hence, we can choose tracking error as a reasonable proxy for factor bets and Active Share for stock selection,” the professors say.

“Generally the higher the active share, the higher the tracking error but it’s not a one-for-one relationship,” Elston says. “By mapping a fund universe according to active share and tracking error, you can start to categorise funds according to where they sit on that matrix.”

So, according to the research, a diversified stock picker can be very active despite low tracking error, because stock selection within industries can still lead to large deviations from the index portfolio.

“In contrast, a fund betting on systematic factors can generate a large tracking error even without large deviations from index holdings. A concentrated stock picker combines the two approaches, thus taking positions in individual stocks as well as in systematic factors,” say the professors.

A closet indexer scores low on both dimensions of active management while still claiming to be active. It is this final category that tends to give active management a bad name.

Elston says: “Our enemies are the active managers who perform poorly and give the rest of us a bad name.”

And the closet indexers are the managers whose performance is shown to be lacking, according to the active share measure.

©2011 funds europe