Active Share and Tracking Error Screen
Find genuinely active funds without accepting unrelated benchmark risk
- Difficulty
- Moderate
- Time to result
- ~weeks to results
- Steps
- 6
- Confidence
- 97%
Start with the fund's benchmark, then examine how substantially its holdings differ from that benchmark. Active share captures this differentiation: a portfolio owning nearly every benchmark constituent has little room to produce meaningfully different results after fees. High active share alone is insufficient, however, because a manager can inflate it by holding unrelated instruments or making broad directional bets. Tracking error adds the second control by showing how volatile the portfolio is relative to its benchmark. The desired profile is meaningful active share with tracking error that remains consistent with the fund's mandate. Investors must then test whether the manager's long-term net results justify the fees and whether they can tolerate the resulting periods of underperformance without selling at the wrong time.
Origin
Extracted from Masters in Business, where Andrew Slimmon explains how investors can distinguish genuinely active portfolios from expensive benchmark-hugging funds.
Core principles
- 01Active fees require meaningful differentiation from the benchmark.
- 02High active share creates an opportunity to outperform but does not guarantee skill.
- 03Tracking error reveals whether differentiation comes from unrelated directional bets.
- 04Fees can overwhelm the small performance difference of a benchmark-hugging fund.
- 05Performance should be judged over a period long enough to include difficult markets.
How to run it
- 1
Establish the benchmark
Confirm the index against which the fund claims to invest and be evaluated. Without a relevant benchmark, neither active share nor tracking error is meaningful.
Pro tip Check the prospectus rather than relying only on the category shown by a fund platform.
Watch out A conveniently chosen benchmark can make ordinary performance appear exceptional.
- 2
Inspect portfolio overlap
Compare the fund's securities and weights with those of the benchmark. Broad overlap suggests the investor may be buying index-like exposure at an active price.
Pro tip Look beyond the number of holdings and compare position weights as well.
Watch out A long holdings list can conceal substantial benchmark replication.
- 3
Evaluate active share
Use the published active-share figure or calculate how much the portfolio differs from the index. Require enough differentiation to make net outperformance plausible.
Pro tip Compare the result with funds pursuing the same mandate.
Watch out High active share indicates difference, not investment skill.
- 4
Check tracking error
Determine how volatile the portfolio has been relative to its benchmark. Investigate whether excessive tracking error comes from instruments or exposures outside the stated strategy.
Pro tip Review tracking error across multiple market environments.
Watch out Unrelated bets can create high active share while undermining benchmark relevance.
- 5
Test value after costs
Compare long-term net returns, fees, turnover, and taxes with the benchmark alternative. The manager's differential must be large enough to compensate for active costs.
Pro tip Use investor returns and after-fee results when available.
Watch out Gross performance can obscure the drag that investors actually experience.
- 6
Assess behavioral fit
Decide whether you can remain invested through periods when the fund visibly trails its benchmark. A sound strategy still fails the investor who repeatedly buys after gains and sells after losses.
Pro tip Write down the conditions that would justify selling before investing.
Watch out Short-term performance chasing can turn strong fund returns into poor investor returns.
In the wild
An investor reviews an S&P 500 fund holding roughly 400 index constituents while charging an active fee. Its active share is low, so even competent security selection is unlikely to create enough return differential to overcome the cost gap. The investor replaces it with either a low-cost index fund or a genuinely differentiated manager.
→ The investor stops paying an active price for largely passive exposure.
A global-equity manager reports high active share but achieves it partly through bonds, currencies, and copper futures absent from the MSCI World benchmark. The investor examines tracking error, recognizes that the portfolio contains unrelated directional risks, and rejects it despite the impressive active-share statistic.
→ The investor avoids mistaking off-mandate risk for stock-selection conviction.
Common mistakes
Treating active share as proof of skill
Active share only establishes that a portfolio differs from its benchmark. A highly differentiated manager can still make consistently poor selections.
Ignoring the source of tracking error
A fund may depart from its benchmark through unrelated assets rather than superior security selection. Investors should determine which exposures actually produce the volatility.
Chasing recent performance
Buying after a strong year and selling after a weak one can cause an investor's return to trail the fund's published return dramatically.
Is it for you?
Best for
It is best for investors and advisers evaluating whether an active equity fund offers meaningful, benchmark-relevant differentiation.
Not ideal for
It is not ideal as a standalone test of manager skill because differentiation can amplify poor decisions as easily as good ones.
From the transcript
“So active share measures how much you differ from the index.”
“So what you really want. To have in this business is higher actors share, but not a lot of tracking her.”
“If you're going to go active, well, then go active.”
From the episode
At the Money: Avoid Closet Indexing