Tag Archives: etfs

Beyond The Benchmark: Tracking Error Vs. Active Share

Summary We have reservations about using tracking error to gauge “active investing” because it relies on historical volatility data versus a benchmark to draw conclusions about risk. Active share, in our view, provides a clearer picture of how active a fund manager is as compared with drawing conclusions from standard deviation calculations. We believe the fund has to be meaningfully different to its benchmark to create an opportunity to deliver alpha. We believe active share more clearly shows how a fund and benchmark differ, a key to delivering alpha. By Rob Stabler, Product Director Active share, a tool for demonstrating how a fund’s portfolio differs from its respective benchmark, has been a common term among active investors over the last few years. Tracking error, which has a much longer history, is often regarded as another tool that does the same job. But the differences between the two measures affect how Invesco’s Global Opportunities investment team views their effectiveness and usefulness for investors. Tracking error: Useful from returns perspective Tracking error – the divergence between price behaviors of a portfolio and its benchmark – is a backward looking tool, using historical data to show the volatility of the fund’s returns versus that of its benchmark. It’s useful in demonstrating how closely a portfolio follows its benchmark from a returns perspective. However, it’s important to consider these two questions: What’s the benchmark? A fund with a low tracking error versus a volatile benchmark may not produce the return profile investors seek. Are upside and downside volatility equally important to investors? The most common method of assessing tracking error involves calculating the standard deviation of the fund and benchmark returns, which reflects both upside and downside volatility. In our experience, however, investors have been more concerned about the implications of downside volatility. More importantly, as active investors, our team’s main reservation about tracking error is acceptance of the benchmark as the right reference point for measuring volatility and, by implication, risk. In contrast, the investment world doesn’t revolve around the benchmark for our fund managers. We define risk as the potential for permanent loss of capital, using maximum drawdown and downside volatility as indicators. And we often view volatility – at least in the short term – as an opportunity to exploit valuation anomalies in the stock market. Active share: Looks at holdings and weightings Active share is a much simpler calculation that provides a snapshot in time. It measures how different a portfolio is from its benchmark by comparing the fund’s holdings and their weightings with those of the benchmark. We believe active share provides a clearer picture of how active a fund manager is than drawing conclusions from standard deviation calculations. In simple terms, a tracker fund that perfectly replicates its benchmark will have an active share of 0%, while an active fund that owns no constituents of its reference benchmark will have an active share of 100%. This measure is increasingly important, given the rise of passive investing and the need to differentiate between quasi-passive and genuinely active managers. Origin of active share The concept of active share was introduced in research by Martijn Cremers and Antti Petajisto, which indicated that portfolios with a high active share were, on average, likely to outperform their benchmarks, suggesting a positive correlation between performance and active share. 1 Additional research by Cremers and fellow economist Ankur Pareek 2 combined active share analysis with portfolio managers’ stock holding period, where long duration is defined as more than two years. The research shows clear outperformance, on average, of those strategies that combine high active share and long duration, or low turnover, of stocks. Of course, past performance does not guarantee future results. Earlier this year, Invesco published a white paper examining the historical outperformance of active management , using active share as the measuring stick for active management. Because high active share offers no performance guarantee, it’s possible to have a high active share portfolio that underperforms its benchmark. However, our team believes that to outperform a benchmark, portfolio construction needs to differ from the benchmark, and active share is a reliable, easy way of measuring this. So while active share doesn’t guarantee performance, we believe it’s a prerequisite – if you aren’t different, then you can’t hope to achieve a different result, good or bad. By-product of investment philosophy While we don’t explicitly target a high active share in the Invesco Global Opportunities strategy, it’s a by-product of our investment philosophy – concentrated and flexible investing that views risk as absolute, not relative. The result is an active share that is typically high, currently at 95%. Put simply, to create an opportunity to deliver alpha for our investors, we believe the fund has to be meaningfully different from its benchmark. In addition, we see no evidence to suggest a direct link between the strategy’s tracking error and performance. Sources “How active is your fund manager? A new measure that predicts performance,” Aug. 7, 2006. Patient Capital Outperformance: “The Investment Skill of High Active Share Managers Who Trade Infrequently,” Sept. 19, 2014. Important information Alpha refers to the excess returns of a fund relative to the return of a benchmark index. Standard deviation measures a portfolio’s range of total returns and identifies the spread of a portfolio’s short-term fluctuations. Drawdown is the largest cumulative percentage decline in net asset value as measured on a month-end basis. Absolute return refers to the return an asset achieves over a certain period of time, without comparison to another measure or benchmark. The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE All data provided by Invesco unless otherwise noted. Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd. ©2015 Invesco Ltd. All rights reserved. Beyond the benchmark: Tracking error versus active share by Invesco Blog

Expected Returns For The Next Ten Years

According to Jack Bogle and Michael Nolan, U.S. stocks are projected to gain about 6% per year over the next decade. Bonds are projected to earn about 3%. These return projections are significantly lower than the long-term averages of 9% and 4.5%, respectively. For the bond market, future returns are expressed as the current yield to maturity. The yield to maturity on 10-year Treasuries is 2.4%, which Bogle and Nolan round up to 3%. (This could be justified by the addition of higher-yielding bonds.) Since today’s 10-year Treasury yield is 2.3%, that estimate looks reasonable. Stock market returns have three components: the market’s current dividend yield the estimated annualized growth in corporate earnings the expected change in the market’s price/earnings ratio Stock Returns = dividend yield + earnings growth +/- (change in P/E ratio) With the stock market today yielding about 2% and historical earnings growth of 4.7%, Bogle/Nolan arrive at a preliminary estimate of about 7% per year, which they reduce to 6% by figuring that today’s P/E ratio will end up ten years from now at its long-term average of 17.8. Enterprise Returns and Speculative Returns Bogle took inspiration from John Maynard Keynes. Keynes believed that the best economic models are as simple as possible, with components and results that are clearly understood. For example, stock returns could be decomposed into two sources: enterprise returns, which are the returns that came from the growth (or shrinkage) of the intrinsic business, and speculative returns, which come from changes in investor psychology. Bogle uses Keynes’ framework to construct his model. Dividend yield plus earnings growth measures the stock market’s enterprise returns. The last Bogle term – the change in the P/E ratio – equates to Keynes’ concept of speculation. What’s An Investor To Do? First, expect lower than usual returns from both stocks and bonds. There’s no way for bonds to achieve high returns, given a starting yield of 2.4%. As usual, stocks offer less certainty. It’s possible that continued low inflation justifies a market P/E ratio of 25 or higher, leading to annualized stock-market gains that approach 10%. But it is also very easy to envision scenarios that fall short of Bogle’s estimate. The 6% estimate is not overly cautious. Second, inflation-adjusted returns look a little less onerous. Bogle’s models don’t take into account the effects of inflation, but today’s bond yields implicitly forecast low future inflation. If that proves true, bonds could eke out a modest real gain. Stocks would of course fare even better. A 6% nominal gain with 2% inflation means a 4% real return, which is respectable if not spectacular by historic standards and flat-out terrific compared with the paltry yields now paid by Treasury Inflation-Protected Securities. Third, the relationship between stocks and bonds looks normal. The historic return premium offered by stocks over bonds has been 4.6%. That would suggest a modest relative advantage for bonds. On the other hand, because bond yields are so depressed today, the ratio of stock-to-bond returns is not particularly low. Bogle and Nolan find no relationship between forecast equity premiums and future stock returns. Investors have to make some important decisions. If they keep their asset allocations as they are, they will probably end up with smaller account balances than they had hoped for in ten years. Bogle and Nolan do not interpret their findings as suggesting that investors should change their asset allocations. If lower account values are not acceptable, investors can either take more risk, or increase their savings rate to make up the expected shortfall. Neither of these is an ideal solution. Taking more risk will not guarantee a better outcome in ten years. And many investors simply can’t increase their savings rate due to already-stretched finances. But it’s important to face up to the fact that the expected returns over the next ten years are going to be lower than usual. Ignoring this warning and hoping for the best is an option, but not a very practical one.

Selectivity: The New Way Forward For Investors

We believe these changes position investor portfolios to capture what we view as the best opportunities in global equity markets that we expect to play out over the next several years. More specifically, some of the broader changes we’ve made are from a thematic perspective: Equity and multi-asset class portfolios underwent a fairly significant reorientation away from companies levered to the commodity complex (i.e., the Energy and Materials sectors) to those more levered to services/consumption (i.e., the Information Technology and Healthcare sectors). Portfolios also continue to have significant exposure to the Consumer Discretionary sector as we seek to capitalize on service/consumption trends. Additionally, we notably decreased exposure to the Industrials sector and meaningfully increased exposure to Consumer Staples in our Non-U.S. Equity portfolios. Equity positioning is driven by our bottom-up, fundamental research, complemented by our top-down macroeconomic viewpoints. Primary driving factors behind the portfolio repositioning include: The waning commodity supercycle, combined with China’s structural transition from an investment-driven model of growth to one driven more by consumption. And more broadly: Emerging markets’ burgeoning middle class, along with ongoing advancement in emerging market consumers’ wealth. China’s economic transformation does indeed present the risk that Chinese GDP deviates from investor expectations. The transition to a slower – albeit more stable and sustainable – pace of growth, however, is necessary and well underway, as evidenced by GDP and Purchasing Managers’ Index (PMI) data. Data showing contribution to real GDP is released annually in China. The most recent release shows that in 2014, consumption contributed more to GDP growth than investment. More recently, PMI data shows that activity in the services sector continues to expand (i.e., a reading above 50), whereas manufacturing activity has been contracting. This suggests that the rebalancing story continues to play out. (click to enlarge) More broadly, emerging market consumers currently spend only a fraction of what their developed world counterparts spend, due in large part to income disparities. As the emerging markets’ middle class grows, consumer spending on goods and services should become larger contributors to GDP. According to McKinsey & Company, emerging markets’ consumption is expected to equal $30 trillion by 2025, a 150% increase from 2010. (click to enlarge) In our view, all of these dynamics present long-run opportunities for investors seeking growth. We believe that the changes in our portfolio positioning will enable investors to benefit from the trends that we think will move global equity markets over the next several years. Nevertheless, flexibility is paramount to any investment strategy in order to adapt to an ever-changing economic backdrop. To be sure, a selective approach is critical, as opportunities are far from uniform across all countries and sectors. Learn more about the importance of selectivity in today’s environment, in our latest video series from our investment team experts. 1 Source: Winning the $30 trillion decathlon