They Can’t All Be That Smart
A Due Diligence Framework for Factor Investors (Part 2)

Categories Author: Chris Meredith, Insight, Investing

Part 1 of this article delineates factor-based strategies — fundamental weighting,1 smart beta, and Factor Alpha — by showing the differences between them. Also covered in Part 1 is a comparison of risk-focused and return-focused factor implementation.2

Part 2 covers how risk controls3 and using Active Share4 can help determine the alignment between factors and portfolio construction for, as well as the fees you should expect to pay.

Using Risk Controls

Changing weighting schemes creates active risk with the passive market cap-weighted benchmark. The portfolio construction process used above was basic as the active constituents were equally weighted. This active weighting creates the opportunity for outperformance, but also creates differences with the benchmark. Part of this risk comes from the alpha source: investing in high-yielding companies does generate excess return over long periods of time, but can also create periods of time when it underperforms. But some of the risk comes from other bets created when the portfolio is formed: differences in sectors, like an overweight to Energy, or differences in factors, like an underweight to Market Cap.


Sector differences are a large driver in these differences of returns. The table below shows some of the choices made in the basic analysis above. When trimming the bottom 5% of stocks by market cap to avoid small caps, you introduce 46bps of tracking error. But when moving from the market cap-weighted portfolio to equally-weighted constituents, the tracking error jumps to over 4%. This is the same universe of stocks as the market cap-weighted, but simply unwinding the market cap factor used in the passive benchmark creates large active risk for the portfolio.

To manage active risk, you can adjust the portfolio from equally-weighted to a risk-controlled weighting on sectors. In the basic example below, by controlling for active sector allocations and shaping the portfolio back to the same weightings as the benchmark can remove over 125bps of the active risk.

Active Percentages

The question is how broad of a portfolio do you need in order to take advantage of risk controls like sector awareness. Taking this same usage of sector risk-controls back to the Factor Alpha framework, another analysis was run utilizing the same percentages of Shareholder Yield, but with an additional set of risk controls to reduce exposures versus the benchmark. To be explicit, the portfolios are formed selecting on the strength of a factor, but instead of equally-weighting the stocks we see if we can shape the portfolio to get the sector exposures as close as possible to the benchmark. Sector weightings are not neutralized, as the focus is on generating excess return through factors, but they are more controlled than in an equally-weighted portfolio.

With highly concentrated portfolios of only 2.5% to 5% of the universe, there is little room to maneuver the portfolio sectors. But by the time we have expanded to just the top decile of the factor, which is only about 30–50 names, risk-controls are able to shape the portfolio and reduce the overall active risk. This approach reduces active risk while maintaining the same profile of excess returns and active exposures versus the benchmark, increasing the risk-adjusted return through the Information Ratio significantly.

There are a number of ways to introduce risk controls, through risk models or explicit constraints. And smart beta also has the ability to add risk controls. Again, the difference will come down to the philosophy of what is being delivered. The smart beta approach starts with de minimis risk, and gradually dials up alpha. A Factor Alpha approach has the ability to deliver significant excess return while managing active risk in the portfolio.

Through the Lens of Active Share

Validating Portfolio Construction
Not all factor-based investing approaches are smart, but there are several different ways to construct smart portfolios. Both smart beta and Factor Alpha approaches can generate strong risk-return profiles, with one approach focusing on risk while the other focuses on returns, but in either approach there can be misalignment between the return of factors and the portfolio construction methodology.

When analyzing a factor portfolio, you should determine (1) the breadth of the excess return from the alpha signal and (2) whether the manager is using a risk-focused smart beta or a return-focused Factor Alpha approach. In either approach, Active Shares should line up with where signal conviction diminishes. If they don’t, it’s possible that the manager has a misalignment in portfolio construction.


Analyzing Fees
Active Share also helps establish what the fee of a product should be. It disaggregates the passive component of every strategy, contextualizing the fees being paid to an active manager. Fees are under a tremendous pressure in our industry. The 2016 ICI Factbook shows that, since 2000, the average fee paid to equity mutual fund managers has declined from 99bps to 68bps, a decline of 31%. The shift to passive management has been a component of this, but fee renegotiation is part of the decline. The average fee on active equity has declined from 106bps to 81bps, a decline of 21%, which means about half of the decline in overall fees paid is from compression of the fees paid to active management.
Active Share gives transparency to what you are paying for. The average passive index fund is at 11bps. The lowest-cost ETFs are trading at 5bps, and large institutions can get passive exposure for a single basis point. What Active Share gives is a quick metric into how much of the portfolio is passive, with the idea that the passive component of investments is commoditized.

The difference between a smart beta and a Factor Alpha approach to building a portfolio shows why there should be a different fee structure between the two approaches. Smart beta comes with a large passive component to its portfolio, which should come at passive costs. The Factor Alpha approach has little passive exposure because the bulk of its investments are in the skill of the manager.


Both smart beta and Factor Alpha approaches allow for exposure to factors which can enhance returns, but the implementations are very different. After you figure out your cost for market access, there are only two inputs to determine what one should be willing to pay for a manager: what’s the estimated skill on the active component of the portfolio, and how much are you willing to pay for that skill?

Once those two numbers are nailed down, they are simply inputs into the formula. Let’s propose a smart beta example where the cost of passive market access is 10bps, and the skill of the alpha is determined to be 4% and you’re prepared to pay 20% of alpha to get access to that skill. Based on the Active Share, you can determine an expected fee for the portfolio no matter the approach that it’s using.


Active Share helps identify misalignments between construction methodology and fees in the industry. The website Activeshare.info5 has constituent data for mutual funds and exchange traded funds and explicitly calculates the Active Fee using this same methodology, and can help investors avoid misalignments. Misalignments in portfolio construction isn’t just limited to quantitative managers. Fundamental managers also struggle with quantifying their skill and how to implement it in a portfolio. With either approach, one should analyze low-Active Share portfolios with average to above average fees to determine whether they have an incredible alpha source on their active component, or determine if they are misconstructed or mispriced. High Active Share at below-average fees offers an opportunity for lower cost access to investment skill, and the investigative burden should center on validating the skill of the manager.

This may be old news to industry professionals. The following tables show the asset distribution of Large Cap Funds broken down by Active Share and Expense Ratios. The universe includes all mutual funds and exchange traded funds that have coverage in the CRSP Mutual Fund Database, and have holdings and returns in the database. Active share is broken into three groupings which broadly align with the Smart Beta, Potentially Misaligned, and Factor Alpha quantitative approaches. Fees are broken out by 30bps increments.
The table shows two distinct trends. The first is well known as the industry has shifted to lower fees, with almost half of fund assets now paying fees under 30bps and the average fee by assets is down 33% over the last 10 years.

There is a second trend in the industry over the past 10 years: a shift away from the Potentially Misaligned. Almost the entire shift to passive investments has come from funds with an active share of 33–66%. It should be noted that these posts of 33–66% are arbitrary, but the trend maintains if you shift the breakpoints to 40 and 60%, or 25 and 75%. High Active Share strategies have only had a moderate loss to their overall market share. The shift within the space is leaving a “barbell” of solutions, moving towards a risk-focused passive or Smart Beta benchmark-aware process, or the highly active return-focused approach like Factor Alpha. If this trend is continuing, there is over $1.1 trillion remaining in the Potentially Misaligned funds and those funds — funds that are on the edge of either lower conviction or higher fee — will likely be next to see assets shift away from them.

U.S. Large Cap Equity Funds
by Active Share and Expense Ratio


Understand the source of alpha.
Factors are not commodities (see this post), and can have large differences between quantitative managers. It’s important to not only know the strength of outperformance in the top names but also have an understanding of the breadth of the signal. The broader the alpha, the more appropriate it is to have a higher Active Share in smart beta, and a lower Active Share in a Factor Alpha approach. Most alphas degrade quickly after the top decile and turn low conviction by the top third of the universe.

“Smart beta” and Factor Alpha start with different goals.
Smart beta is an approach focused on minimizing risk, while Factor Alpha is focused on maximizing the excess return versus the benchmark. Both provide similar Information Ratios, which degrade at a rate determined by the alpha signal. But to borrow a common phrase in finance, “you can’t eat an Information Ratio.” To be more explicit, returns are going to achieve investors’ funding goals, not risk controls. Investors seeking returns should consider Factor Alpha portfolios.

Risk controls matter.
In either approach, having a layer of risk controls significantly improves the risk-return profile. In Factor Alpha, you can maintain the excess return while lowering the excess risk, improving the Information Ratio significantly.

Investigate portfolios for construction alignment and fees.
Knowing a manager’s investment focus, Active Share and alpha signal allow for an advisor to determine if there is a misalignment in the construction of the portfolio. Active Share also helps determine whether the investment solution is priced appropriately.

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  1. Weighting on sales or earnings is an indirect value signal, but without controlling for price.
  2. Smart beta is focused on risk; Factor Alpha is focused on returns.
  3. Risk controls help augment a return-focused Factor Alpha process.
  4. Active Share can be a useful guideline for helping allocators to understand the alignment of alpha signal and portfolio construction, as well as understand appropriate fee structures.
  5. Launched in 2016.