Active share comes with additional risk
Given this, it would be easy to select funds with high active share in the hope of outperforming, but a higher active share comes with additional risk versus an index. It can result in material performance deviation relative to an index on both the upside and downside. The key question is whether the level of active share the manager consistently takes is sufficient to achieve their investment objective.
For example, let’s say you want your next investment to have highly defensive qualities that help preserve capital in downmarkets. You accept that it will lag rallying markets but the compounding effect provides an attractive return profile.
A passive, ETF-based approach would be inappropriate as this would track the market on both the upside and downside. A strategy demonstrating a defensive profile will typically have a high degree of active share as it will principally invest in market segments and individual stocks that prove to be more resilient through periods of stress and away from large proportions of the index that may prove more volatile and susceptible in downturns.
Applying the above approach when investing in Asia ex-Japan, for instance, if you choose to go down the ETF route as an investor you will inadvertently have gained significant exposure to Chinese banks, which many risk-averse investors would be keen to avoid.
Many of the active managers generally steer clear of China on the basis of poor corporate governance and opaque balance sheets, which results in high active share as these investments are a large proportion of the MSCI index. The obvious risk of this approach is that if the banks bounce (as they have done this year) it can be a detractor to performance, but for many investors they are happy to accept lower returns in this scenario, believing a higher quality approach will provide greater and less volatile returns over the longer-term.
