Michael Mauboussin - Seeking Portfolio Manager Skill 2-24-12

February 24, 2012
Seeking Portfolio Manager Skill

Active Share and Tracking Error as a Means to Anticipate Alpha
Annualized Four-Factor Alpha
1.5%
1.0%
0.5%
0.0%
-0.5%
-1.0%
-1.5%
-2.0%
-2.5%
Closet
Indexers
Moderately
Active
Factor
Bets
Concentrated
Stock
Pickers
Source: Antti Petajisto, Active Share and Mutual Fund Performance, Working Paper, December 15, 2010.
Page 1
There is a logical case for active management, but the key challenge is
identifying above-average portfolio managers ahead of time.
Most statistics in the investment industry and corporate America fail the
dual test of reliability and validity.
Active share and tracking error are both reliable statistics, and research
shows that funds with high active share and moderate tracking error
deliver excess returns on average.
The long-term trend has been toward lower active share, which makes it
difficult for mutual funds to generate sufficient gross returns to offset fees.
Legg Mason Capital Management
Equity markets are generally considered to be informationally efficient, which means that all
relevant information is impounded in prices. Because it is difficult for an active manager to
generate returns in excess of that of the market after an adjustment for risk, a common
prescription is to turn to passive management in the form of index funds. This is a sensible
approach for many investors. But the case for passive management has logical limits. For
example, in economics there is an idea called the macro consistency test, which asks, Would
this approach work if everyone pursued it? The answer for passive investing is no. Some
percentage of investors must be active in order to ensure that information is translated into prices.
Indeed, recent research shows that active management enhances, and passive management
reduces, the informational efficiency of stock prices.1
In 1980, a pair of economists, Sanford Grossman and Joseph Stiglitz, wrote a seminal paper
called, On the Impossibility of Informationally Efficient Markets. 2 Their basic argument is that
there is a cost to making sure that prices properly reflect information. If there is no return for
obtaining and trading on information, there is no economic incentive to do so. They propose that
those who do expend resources to obtain information do receive compensation in the form of
excess returns. In-depth studies show that active managers do indeed generate gross returns in
excess of those of the market. 3 However, those returns are less than the fees that managers
charge. Careful studies of active management also reveal differential skillthat is, luck alone
does not explain the results in investment management and a small percentage of managers
deliver positive excess returns after all costs. 4
Of course the challenge is to identify skillful managers ex ante. There are two major approaches
to assessing manager skill. 5 The first relies on an analysis of prior returns. The effectiveness of
this approach relies on extracting useful information about skill by considering a sufficiently long
time period and by controlling for various factors, including the types of risks the manager has
assumed and the systematic versus idiosyncratic risk exposure. Returns-based assessments
rarely make sufficient and appropriate adjustments to distill skill from the reported results. Further,
simulations show that even skillful managersthose endowed with an attractive ex-ante Sharpe
ratiocan deliver poor returns for years as a consequence of luck. 6 In other words, even skillful
managers wont always beat their benchmarks and unskillful managers can do well for stretches
of time as the result of randomness.
The second approach to testing manager skill is look at the portfolio holdings and characteristics
of managers. Characteristics might include a portfolio managers age, education, and the size of
his or her fund. The focus on portfolio construction and holdings allows for a more precise
assessment of a managers process. The focus of this discussion will be on active share, a
concept developed by a pair of finance professors named Martijn Cremers and Antti Petajisto, as
a means to increase the probability of identifying a skillful manager in advance. 7
What Is the Characteristic of a Valuable Statistic?

The worlds of finance and investing are awash in statistics that purport to reflect whats going on.
Statistics that are useful have two features: reliability and validity. 8 Reliability means that results
are highly correlated from one period to the next. For example, a student who did poorly on a test
last week does poorly this week, and the student who did well last week does well this week. High
reliability and a large contribution of skill generally go together. Finance researchers use the term
persistence, which is the same as reliability.
The second feature is validity, which means the result is correlated with the desired outcome. For
instance, say a baseball teams offensive goal is to score as many runs as possible. An analysis
would show that on-base percentage is better correlated with run production than batting average
is. So an enlightened manager would prefer on-base percentage to batting average as a statistic
of offensive production, all else being equal.
Page 2
The returns-based approach skips the two steps of reliability and validity and goes directly to the
results. It doesnt pause to ask: what leads to excess returns? It just measures the outcome. This
approach works in fields where skill determines results and luck is no big deal. For example, if
you have five runners of disparate ability run a 100-yard dash, the outcome of the race is a highly
reliable predictor of the next race. You dont need to know anything about the process because
the result alone is proof of the difference in ability.
The difficulty with using a returns-based approach to assessing skill is that there is not a great
deal of reliability, or persistence, in measures of excess returns. Researchers do find evidence for
modest persistence but only when returns are carefully adjusted to account for style factors. 9 But
correlations over short periods, say year-to-year, for alpha based on the capital asset pricing
model (CAPM) are quite low.
This problem of low reliability applies broadly to any highly competitive field that is probabilistic.
Results, and especially short-term results, cannot distinguish between a good process and a poor
process because of the role of luck. So going directly to the results gives little indication about the
quality of the decision-making process and the skill of the participant.
In contrast, the approach that considers the holdings and characteristics of the manager allows
us to look at both reliability and validity. Now the discussion shifts a bit. The questions become:
which measures of an active managers portfolio reflect skill and therefore reliability? For
example, a manager may be able to control the number of holdings, risk, turnover, and fees.
Next, of the measures that are reliable, which are highly correlated with the ultimate objective of
delivering excess returns? Are there measures that are both reliable and valid?
Active Share + Tracking Error = Indicator of Skill

Lets now take a closer look at active share. In plain language, active share is the percentage of
the funds portfolio that differs from the funds benchmark index. 10 Assuming no leverage or
shorting, active share is 0 percent if the fund perfectly mimics the index and 100 percent if the
fund is totally different than the index.
More technically,
Active Share =
1 N
fund ,i index,i
2 i =1
where:
fund,i = portfolio weight of asset i in the fund
index,i = portfolio weight of asset i in the index
Heres a really simple example. Say the index has 10 stocks, weighted as follows:
Index Holdings
Position
Weight
Stock 1
20.0 %
Stock 2
15.0
Stock 3
12.0
Stock 4
11.0
Stock 5
10.0
Stock 6
9.0
Stock 7
8.0
Stock 8
7.0
Stock 9
5.0
Stock 10
3.0
Total
100.0
Page 3
Now lets say we have a fund of 10 stocks, weighted as follows:

Fund Holdings
Position
Weight
Stock 1
10.0 %
Stock 2
0.0
Stock 3
5.0
Stock 4
3.0
Stock 5
20.0
Stock 11
15.0
Stock 12
12.0
Stock 13
11.0
Stock 14
9.0
Stock 15
15.0
Total
100.0
Active share is the sum of the absolute values of the difference between the weight in the index
and the weight in the fund, divided by two:
Position
Stock 1
Stock 2
Stock 3
Stock 4
Stock 5
Stock 6
Stock 7
Stock 8
Stock 9
Stock 10
Stock 11
Stock 12
Stock 13
Stock 14
Stock 15
Total
Index Weight
20.0%
15.0
12.0
11.0
10.0
9.0
8.0
7.0
5.0
3.0
0.0
0.0
0.0
0.0
0.0
100.0
Fund Weight
10.0%
0.0
5.0
3.0
20.0
0.0
0.0
0.0
0.0
0.0
15.0
12.0
11.0
9.0
15.0
100.0
Active Share
5.0%
7.5
3.5
4.0
5.0
4.5
4.0
3.5
2.5
1.5
7.5
6.0
5.5
4.5
7.5
72.0%
In this basic example, you can see that active share is the result of not owning, or weighting
differently, the stocks in the index (see stocks 1-10) and owning stocks that are not in the index
(see stocks 11-15).
Generally, an active share of 60 percent or less is considered to be closet indexing and active
shares of 90 percent or more indicate managers who are truly picking stocks. For the past 30
years, active share has been declining steadily for the mutual fund universe in the United States.
For instance, the percentage of assets under management with active share less than 60 percent
went from 1.5 percent in 1980 to over 40 percent today.
The selection of an index as a benchmark is obviously crucial. Research by Antti Petajisto shows
that of the roughly 2,500 mutual funds he analyzed, 38.6 percent used the S&P 500 as their
benchmark. Weighted by assets, 56 percent of the funds use the S&P 500 as a benchmark.
Other popular benchmarks include the Russell 2000 (8.8 percent by number, 6.2 percent by
weight), the Russell 1000 Growth (8.4 percent by number, 5.6 percent by weight) and the Russell
1000 Value (8.2 percent by number, 8.4 percent by weight). Exhibit 1 shows the most common
benchmark indexes.
Page 4
Exhibit 1: Most Common Benchmark Indexes

60%
50%
40%
Percentage of Funds
30%
Percentage of Assets
20%
10%
0%
S&P 500 Russell Russell Russell Russell Russell Russell Russell Russell
3000
Midcap
Midcap
2000
2000
1000
2000
1000
Value
Growth
Value
Growth
Value
Growth
Other
There are two basic ways to raise active share. 11 The first is through stock selection, as our
simple example shows. That means either buying stocks that are not represented in the index, or
owning stocks that are in the index but at a position weight that is higher or lower than what is in
the index.
The second way to raise active share is through systematic factor risk, which is effectively betting
on factors by overweighting or underweighting industries. For example, a manager who is bullish
on an economic recovery might overweight industries that are economically sensitive, or a
manager who is bearish might overweight defensive industries. Tracking error, the standard
deviation of the difference between the returns of the fund and of the index, does an effective job
in capturing systematic factor risk. Tracking error puts more weight on correlated active bets than
active share does. You can think of active share as a complement to tracking error and a
measure that adds value in explaining fund results. A full picture of active management
incorporates both active share and tracking error.
To illustrate the difference between these measures of active management, Petajisto offers the
following illustration. Say a portfolio has 50 stocks. If all of the overweight positions are in
technology stocks that move together, then small active positions will generate high tracking
error. The portfolio has high systematic risk.
On the other hand, say the index represents 50 industries with 20 stocks in each industry and the
fund selects one stock from each industry but weights that stock at the same level as the industry.
In this case, active share will be high at about 95 percent but the tracking error will be relatively
low. As Petajisto notes, active share is a reasonable proxy for stock selection, whereas tracking
error is a proxy for systematic factor risk.
There is a clear relationship between active share and tracking error. When active share is low,
tracking error tends to be low and when active share is high, tracking error tends to be high. But
the data show some amount of variation. For example, funds with tracking error of 4-6 percent
can have active shares of 30 percent to 100 percent, while active shares in the 70-80 percent
Page 5
range can be associated with tracking errors between 2 and 14 percent. This range of values for
each measure of active management shows why it is important to distinguish between the two.
Exhibit 2 shows a matrix that classifies 401 mutual funds based on active share and tracking error
using data from year-end 2007. The funds were sorted into quintiles based on each measure,
with one as the lowest value and five as the highest value. The cells represent the number of
funds that fall into the intersection of each pairing of quintiles. For example, if you examine the
top right corner, you can see that 47 funds, or 11.6 percent of the sample, are in the highest
quintile of both active share and tracking error. These are funds that are very different than their
benchmarks and that have results that vary quite a bit from their benchmark. In contrast, the
bottom left corner shows that nearly 15 percent of the sample59 fundsare in the lowest
quintile of both active share and tracking error. These are index hugging funds. To be in the top
quintile, a fund must have an active share higher than 91 percent and a tracking error higher than
5.3 percent.
Exhibit 2: 401 Mutual Funds Ranked in Quintiles Based on Active Share and Tracking Error
Tracking Error
Active
Share
5
4
3
2
1
1
0
1
7
13
59
2
1
8
22
34
15
3
4
22
25
24
5
4
29
23
20
7
1
5
47
26
6
2
0
Source: Morningstar, FactSet, and LMCM analysis.
A common measure of portfolio performance is the information ratio, which is excess return
divided by tracking error. There is a fairly linear relationship between large factor bets (i.e., the
overweighting or underweighting of industries relative to the benchmark) and tracking error. So in
order to have an attractive information ratio, those factor bets have to really pay off to
compensate for the high tracking error. Broadly speaking, they dont. So active managers are
better off maintaining high active share through stock picking than through sector bets.
The appendix provides a more sophisticated numerical example of active share and systematic
factor bets based on a fictitious index and fund.
Active Share and Fees

The downward drift in active share raises an important issue in the active versus passive debate.
If youre going to go passive, go passive. Buy a fund that charges low fees and closely mirrors the
index. If youre going to go active, find a manager with a good process and high active share.
Academic research shows, for example, that the best ideas of money managers generate excess
returns. 12
Active managers who have crept toward closet indexing have created a losing proposition
market-like returns accompanied by fees higher than index funds. Petajisto provides an
interesting case with Fidelitys flagship mutual fund, Magellan. Peter Lynch made the fund famous
by delivering outstanding returns in the 1980s when he managed it, in part by sustaining high
active share. When Jeffrey Vinik ran the fund in the early 1990s, it had an active share above 70
percent. However, the funds next manager, Robert Stansky, who took over in 1996, took the
active share below 40 percent and kept it there for a half dozen years.
Heres why its so hard to beat the market with low active share and an average expense ratio.
Say a fund has an expense ratio of 125 basis pointsroughly the average of all funds in
Petajistos studyand the active share is 33 percent. That means that two-thirds of the portfolio
Page 6
is earning the same return as the benchmark index. Therefore, the active part has to make up for
the difference with massive outperformance. For example, in order to equal the benchmarks
returns, the active portion needs to earn an excess return of 375 basis points:
Percentage
of Portfolio
67%
33
100%
Passive
Active
Excess Return
0.00%
3.75
Weighted Return
0.00%
1.25%
Gross return
Less expenses
Net return
1.25%
-1.25%
= 0%
Petajisto did find that low active share funds tended to have lower expense ratios, but the fees
were sufficient to make outperformance extremely difficult. Generating excess returns is
challenging enough, but low active share and average fees make the task even more daunting.
Reliability and Validity

We noted before that the returns-based approach to assessing skill skips the steps of reliability
and validity. Now we apply the features of a useful statistic to active share and tracking error. The
way to test reliability in this case is to examine the coefficient of correlation, r, between the active
share for the same fund over two different time periods. Using a sample of approximately 400
mutual funds, the r between active share for 2007 and 2010 is 86 percent. (See exhibit 3, left
side.) Cremers and Petajisto also found active share to be reliable. This makes sense, because
active share is within the control of a portfolio manager.
Tracking error, too, appears to have good reliability. For the same funds and same time period,
the coefficient of correlation, r, is 76 percent. (See exhibit 3, right side.) To put these figures in
context, three-year alphas based on the CAPM have a coefficient of correlation of close to zero.
Exhibit 3: Reliability of Active Share and Tracking Error
r = 0.86
0.80
0.60
0.40
0.20
0.00
0.00
0.20
0.40
0.60
0.80
2007 Active Share
1.00
r = 0.76
25.00
2010 Tracking Error
2010 Active Share
1.00
20.00
15.00
10.00
5.00
0.00
0.00
5.00
10.00
15.00
20.00
25.00
2007 Tracking Error
Source: Morningstar, FactSet, and LMCM analysis.
The second feature of a useful statistic is validityit leads you to the outcomes that you seek.
The research suggests that high active share is desirable if it is the result of stock picking, but
less desirable if it is the result of factor bets that show up as high tracking error. Petajisto sorts
1,124 funds into five categories based on results from 1990 through 2009 (see exhibit 4). Stock
pickers are in the highest quintile of active share, but in the bottom 80 percent of tracking error
Page 7
within that active share quintile. He labels concentrated the funds in the highest quintile of active
share that have the highest tracking error. These funds have high systematic factor risk. Funds in
the stock pickers category have an average active share of 97 percent with an average tracking
error of 8.5 percent. The concentrated funds have similar active share, at 98 percent, but have a
tracking error of 15.8 percent, which is almost double that of the stock pickers.
Exhibit 4: Fund Categories and Their Statistics (5 = Top, 1 = Bottom)
Label
Stock pickers
Concentrated
Factor bets
Moderately active
Closet indexers
Description
Top quintile AS, quintiles 1-4 TE
Top quintile AS, top quintile TE
Quintiles 2-4 AS, top quintile TE
Quintiles 2-4 AS, quintiles 1-4 TE
Bottom quintile AS, quintiles 1-4 TE
Average
Active Share
97%
98%
79%
83%
59%
Average
Portfolio Number
Average
Tracking Error Turnover of stocks Expense Ratio
8.5%
83%
66
1.41%
15.8%
122%
59
1.60%
10.4%
104%
107
1.34%
5.9%
84%
100
1.25%
3.5%
69%
161
1.05%
Funds that make relatively large factor bets are in the bottom four quintiles for active share but
have among the highest tracking error within those quintiles. Moderately active funds are in the
middle quintiles for active share but have tracking error that is much lower than the funds making
factor bets. Finally, the closet indexers have low active share and low tracking error.
The test of validity is whether these categories correlate with excess returns. Exhibit 5 shows the
results from Petajistos research. Importantly, these results include a period when large
capitalization stocks did well (the 1990s), small capitalization stocks outperformed (the 2000s),
and the financial crisis. Petajisto shows that stock pickers generate annual alpha of 1.39 percent,
whereas all of the other categories have negative alpha. The funds that rely on factor bets are the
worst performing category. However, funds with high tracking error and high active share perform
less poorly.
Exhibit 5: Four-Factor Alpha for 1,124 Funds from 1990-2009 Based on Fund Category
Annualized Four-Factor Alpha
1.5%
1.0%
0.5%
0.0%
-0.5%
-1.0%
-1.5%
-2.0%
-2.5%
Closet
Indexers
Moderately
Active
Factor
Bets
Concentrated
Stock
Pickers
Petajistos large sample over 20 years provides a solid basis to establish validity. The smaller
sample we used to establish reliability provided similar results. The funds that were in the highest
quintile for active share and the bottom 80 percent of tracking error64 funds altogether
generated annualized alpha of 3.8 percentage points from 2008-2010, well in excess of the
results of the sample of all 400 funds.
Page 8
The conclusion is that a thoughtful combination of active share and tracking error reflects the
essential features of a good statistic: they are reliable and valid. Still, active share needs additional
testing before it can be declared sufficient to indicate ex ante skill. One specific concern is
benchmark selection. Small capitalization funds, for instance, tend to have higher active share than
large capitalization funds. This is because small capitalization indexes have more stocks, with a
lower average weight, than large capitalization indexes do. So the favorable results from the
analysis of active share may stem in part from the fact that small capitalization funds beat their
indexes more often than large capitalization funds do.13
Summary
Investment management is a very competitive business, in part because there are so many bright
and motivated people seeking to beat their benchmarks. As a result, randomness plays a large role
in determining results in the short term and it is difficult to deliver excess returns over time. Still,
academic research shows that some funds do better than chance would suggest, and that active
managers beat their benchmarks before fees. The fundamental question is whether funds with a
good chance of outperforming their benchmark can be identified in advance.
There are two approaches to assessing managers. The first examines past results. This approach
can reveal information if the track record is sufficiently long and enough controls are put into place
so as to ensure that the results are not the consequence of risk. But relying on results in any domain
that is based on probability is inherently troublesome, because the challenge of sorting skill and
randomness is daunting.
The second approach studies the characteristics and behavior of the manager in order to assess
whether he or she has a good process. To be useful, any measure of performance must have two
features: reliability and validity. Most manager assessments use statistics that are neither reliable
nor valid. We argue that a combination of active share and tracking error provides a glimpse into
process. Taken together, these statistics are also reliable and valid. Based on this discussion, we
can arrive at four conclusions:
There is a role for active management. Having some active managers is a logical necessity.
Research shows that active management increases the informational efficiency of stock
prices and that passive management makes prices less efficient. The key challenge is
identifying above-average managers ahead of time.
Reliability and validity. Most statistics in the investment industry fail the dual test of reliability
and validity. This is true in corporate America as well. As a consequence, its important to
break down investment results further in order to get a better handle on potential skill.
The combination of active share and tracking error provides insight. Active share and
tracking error are both reliable statistics. For example, for 400 mutual funds (2007 to 2010)
the coefficient of correlation for active share was 86 percent while tracking error was 76
percent. In seeking validity, the goal is to identify funds with high active share (top quintile)
that are not in the highest quintile for tracking error. High tracking error indicates sizeable
factor bets, which tend to deliver poor returns. Research by Cremers and Petajisto,
confirmed by our own smaller sample, shows that funds with high active share and
moderate tracking error deliver excess returns.
There is a long-term trend toward lower active share. The percentage of assets under
management with active share below 60 percentconsidered to be closet indexinghas
risen from 1.5 percent 30 years ago to more than 40 percent today. Passive management
makes sense for a great deal of investors. But the essential message is this: If youre going
to be active, go active. Dont own a fund with low active share, because the chances are
good that the funds gross returns will be insufficient to leave you with attractive returns after
fees.
Id like to acknowledge the intellectual contribution of Arturo Rodriguez, CFA. As always, Dan Callahan, CFA,
added great value in all aspects of preparing this piece.
Page 9
Endnotes:
1
Russ Wermers and Tong Yao, Active vs. Passive Investing and the Efficiency of Individual
Stock Prices, Working Paper, February 2010; Rodney N. Sullivan and James X. Xiong, CFA,
How Index Trading Increases Market Vulnerability, Financial Analysts Journal, forthcoming (see
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1908227; and Jeffrey Wurgler, On the
Economic Consequences of Index-Linked Investing, Challenges to Business in the Twenty-First
Century: The Way Forward, W.T. Allen, R. Khurana, J. Lorsch, and G. Rosenfeld, eds.,
forthcoming (see http://archive.nyu.edu/bitstream/2451/31353/2/4_essay_Wurgler.pdf.)
2
Sanford J. Grossman and Joseph E. Stiglitz, On the Impossibility of Informationally Efficient
Markets, American Economic Review, Vol. 70, No. 3, June 1980, 393-408.
3
Russ Wermers, Mutual Fund Performance: An Empirical Decomposition into Stock-Picking
Talent, Style, Transaction Costs, and Expenses, Journal of Finance, Vol. 55, No. 4, August
2000, 1655-1695.
4
Robert Kosowski, Allan G. Timmerman, Russ Wermers, and Hal White, Can Mutual Fund
Stars Really Pick Stocks? Journal of Finance, Vol. 61, No. 6, December 2006, 2551-2595;
Laurent Barras, Olivier Scaillet, and Russ Wermers, False Discoveries in Mutual Fund
Performance: Measuring Luck in Estimated Alphas, Journal of Finance, Vol. 65, No. 1, February
2010, 179-216.
5
Russ Wermers, Performance Measurement of Mutual Funds, Hedge Funds, and Institutional
Accounts, Annual Review of Financial Economics, Vol. 3, 2011, 537-574.
6
David L. Donoho, Robert A. Crenian, and Matthew H. Scanlan, Is Patience a Virtue? The
Unsentimental Case for the Long View in Evaluating Returns, The Journal of Portfolio
Management, Fall 2010, 105-120.
7
K. J. Martijn Cremers and Antti Petajisto, How Active is Your Fund Manager? A New Measure
That Predicts Performance, Review of Financial Studies, Vol. 22, No. 9, September 2009, 33293365.
8
William M.K. Trochim and James P. Donnelly, The Research Methods Knowledge Base, Third
Edition (Mason, OH: Atomic Dog, 2008), 80-95.
9
The most widely used are Carharts four-factor model (CAPM, size, valuation, momentum) and
the Fama-French three-factor model (CAPM, size, valuation). See Mark M. Carhart, On
Persistence in Mutual Fund Performance, Journal of Finance, Vol. 52, No. 1, March 1997, 57-82
and Eugene F. Fama and Kenneth R. French, Common Risk Factors in the Returns of Stocks
and Bonds, Journal of Financial Economics, Vol. 33, No. 1, February 1993, 3-56.
10
Antti Petajisto, Active Share and Mutual Fund Performance, Working Paper, December 15,
2010.
11
Eugene F. Fama, Components of Investment Performance, Journal of Finance, Vol. 27, No.
3, June 1972, 551-567.
12
Randy Cohen, Christopher Polk, and Bernhard Silli, Best Ideas, Working Paper, March 2009.
Also, Klaas P. Baks, Jeffrey A. Busse, and T. Clifton Green, Fund Managers Who Take Big Bets:
Skilled or Overconfident, Working Paper, March 2006.
13
Robert C. Jones, CFA, and Russ Wermers, Active Management in a Mostly Efficient Market,
Financial Analysts Journal, Vol. 67, No. 6, November/December 2011, 29-45.
Page 10
Appendix: Decomposing Active Share

On the left is a fictitious index. The list shows the 50 stocks in the index, which industry each
company is in, and the weight within the index. On the right is our fictitious fund, which has 25
stocks. Note that the stocks in the fund do not overlap completely with the stocks in the index. In
other words, the fund holds some stocks that are not in the index.
Index Holdings
Energy Company 6
Information Technology Company 1
Energy Company 3
Industrials Company 3
Consumer Staples Company 4
Telecommunication Services Company 4
Health Care Company 3
Financials Company 7
Consumer Discretionary Company 7
Energy Company 2
Energy Company 5
Energy Company 4
Materials Company 1
Utilities Company 6
Materials Company 4
Materials Company 3
Materials Company 2
Materials Company 6
Utilities Company 2
Utilities Company 3
Utilities Company 4
Utilities Company 5
Total
Page 11
Weight
7.7%
7.2%
4.1%
4.0%
3.7%
3.6%
3.5%
3.4%
3.4%
3.2%
3.1%
3.0%
2.8%
2.6%
2.6%
2.4%
2.3%
2.2%
2.2%
2.0%
2.0%
2.0%
1.8%
1.7%
1.7%
1.5%
1.4%
1.3%
1.3%
1.3%
1.2%
1.2%
1.2%
1.1%
1.1%
1.1%
1.1%
0.8%
0.8%
0.7%
0.7%
0.6%
0.6%
0.6%
0.6%
0.5%
0.5%
0.4%
0.1%
0.1%
100.0%
Fund Holdings
Energy Company 4
Energy Company 1
Materials Company 7
Materials Company 6
Materials Company 5
Utilities Company 5
Utilities Company 1
Total
Weight
7.7%
7.1%
7.0%
6.2%
6.0%
5.2%
5.0%
5.0%
4.9%
4.7%
4.7%
4.1%
4.0%
4.0%
3.8%
3.4%
2.4%
2.3%
2.2%
2.2%
2.1%
1.8%
1.5%
1.4%
1.3%
100.0%
The table below shows the calculation of active share by placing the index and the fund next to
one another. This fund has an active share of 88.5 percent. On the left you can see how active
share rises as the result of stock picking. The fund doesnt hold some of the stocks that are the
indexs largest weighting and does hold stocks that are not in the index.
On the right is the active share as the result of sector weights (tracking error captures this well).
Naturally, active share is a blend of stock picking and sector bets. These amounts are related. In
general, high active share via stock picking and relatively low active share via sector bets does
best.
Total Active Share
Holdings
Energy Company 6
Energy Company 3
Energy Company 2
Energy Company 5
Energy Company 4
Materials Company 1
Utilities Company 6
Materials Company 4
Materials Company 3
Materials Company 2
Materials Company 6
Utilities Company 2
Utilities Company 3
Utilities Company 4
Utilities Company 5
Utilities Company 1
Energy Company 1
Materials Company 5
Materials Company 7
Total
Page 12
Weight in Weight in
Index
Fund
7.7%
0.0%
7.2%
0.0%
4.1%
0.0%
4.0%
0.0%
3.7%
0.0%
3.6%
0.0%
3.5%
0.0%
3.4%
0.0%
3.4%
0.0%
3.2%
0.0%
3.1%
0.0%
3.0%
0.0%
2.8%
0.0%
2.6%
0.0%
2.6%
0.0%
2.4%
0.0%
2.3%
7.0%
2.2%
0.0%
2.2%
0.0%
2.0%
0.0%
2.0%
6.0%
2.0%
0.0%
1.8%
0.0%
1.7%
0.0%
1.7%
0.0%
1.5%
0.0%
1.4%
6.2%
1.3%
0.0%
1.3%
0.0%
1.3%
0.0%
1.2%
0.0%
1.2%
0.0%
1.2%
7.7%
1.1%
2.2%
1.1%
0.0%
1.1%
4.0%
1.1%
4.0%
0.8%
0.0%
0.8%
0.0%
0.7%
0.0%
0.7%
0.0%
0.6%
0.0%
0.6%
2.3%
0.6%
0.0%
0.6%
0.0%
0.5%
0.0%
0.5%
1.8%
0.4%
0.0%
0.1%
0.0%
0.1%
1.3%
0.0%
1.4%
0.0%
4.7%
0.0%
2.2%
0.0%
3.8%
0.0%
5.0%
0.0%
4.1%
0.0%
7.1%
0.0%
1.5%
0.0%
2.1%
0.0%
5.2%
0.0%
2.4%
0.0%
3.4%
0.0%
4.7%
0.0%
5.0%
0.0%
4.9%
100.0%
100.0%
Sector Active Share

Active
Share
3.9%
3.6%
2.1%
2.0%
1.8%
1.8%
1.7%
1.7%
1.7%
1.6%
1.6%
1.5%
1.4%
1.3%
1.3%
1.2%
2.3%
1.1%
1.1%
1.0%
2.0%
1.0%
0.9%
0.9%
0.8%
0.7%
2.4%
0.7%
0.6%
0.6%
0.6%
0.6%
3.3%
0.5%
0.6%
1.5%
1.5%
0.4%
0.4%
0.4%
0.3%
0.3%
0.8%
0.3%
0.3%
0.3%
0.7%
0.2%
0.1%
0.6%
0.7%
2.3%
1.1%
1.9%
2.5%
2.1%
3.6%
0.8%
1.0%
2.6%
1.2%
1.7%
2.4%
2.5%
2.5%
88.5%
Sectors
Energy
Materials
Industrials
Consumer Discretionary
Consumer Staples
Health Care
Financials
Information Technology
Telecommunication Services
Utilities
Total
Weight in Weight in
Index
Fund
16.8%
10.9%
3.4%
6.7%
8.4%
7.9%
6.9%
14.3%
13.1%
13.1%
11.6%
7.2%
10.3%
13.6%
20.4%
17.8%
6.3%
5.4%
2.9%
3.2%
100.0%
100.0%
Active
Share
3.0%
1.7%
0.3%
3.7%
0.0%
2.2%
1.7%
1.3%
0.4%
0.1%
14.3%
The views expressed in this commentary reflect those of Legg Mason Capital Management
(LMCM) as of the date of this commentary. These views are subject to change at any time based
on market or other conditions, and LMCM disclaims any responsibility to update such views.
These views may not be relied upon as investment advice and, because investment decisions for
clients of LMCM are based on numerous factors, may not be relied upon as an indication of
trading intent on behalf of the firm. The information provided in this commentary should not be
considered a recommendation by LMCM or any of its affiliates to purchase or sell any security. To
the extent specific securities are mentioned in the commentary, they have been selected by the
author on an objective basis to illustrate views expressed in the commentary. If specific securities
are mentioned, they do not represent all of the securities purchased, sold or recommended for
clients of LMCM and it should not be assumed that investments in such securities have been or
will be profitable. There is no assurance that any security mentioned in the commentary has ever
been, or will in the future be, recommended to clients of LMCM. Employees of LMCM and its
affiliates may own securities referenced herein. Predictions are inherently limited and should not
be relied upon as an indication of actual or future performance. Legg Mason Capital
Management, LLC consists of two legal entities, Legg Mason Capital Management and LMM
LLC.
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February 24, 2012

Seeking Portfolio Manager Skill

Annualized Four-Factor Alpha

Legg Mason Capital Management

What Is the Characteristic of a Valuable Statistic?

Legg Mason Capital Management

Active Share + Tracking Error = Indicator of Skill

Legg Mason Capital Management

Now lets say we have a fund of 10 stocks, weighted as follows:

Legg Mason Capital Management

Exhibit 1: Most Common Benchmark Indexes

Legg Mason Capital Management

Source: Morningstar, FactSet, and LMCM analysis.

Active Share and Fees

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Reliability and Validity

2007 Active Share

2010 Tracking Error

2010 Active Share

2007 Tracking Error

Source: Morningstar, FactSet, and LMCM analysis.

Legg Mason Capital Management

Annualized Four-Factor Alpha

Legg Mason Capital Management

Legg Mason Capital Management

Legg Mason Capital Management

Appendix: Decomposing Active Share

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Sector Active Share

Legg Mason Capital Management

Legg Mason Capital Management

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