Active shortfall risk

What Is Active Shortfall Risk?

Active shortfall risk is a concept within portfolio theory that quantifies the probability or magnitude by which an actively managed investment portfolio may underperform its designated benchmark. This risk arises from the choices made by an active manager in an attempt to generate returns exceeding those of a passive strategy, such as an index fund. It is a critical consideration for investors evaluating the potential for an active strategy to fail in achieving its stated objective of outperformance after accounting for fees and expenses.

History and Origin

The concept of active shortfall risk is deeply intertwined with the ongoing debate between active and passive investing. While active management has historically been the dominant approach, the rise of passive investing, particularly through index funds and exchange-traded funds (ETFs), brought greater scrutiny to the ability of active managers to consistently beat their benchmarks after fees. This skepticism gained significant traction with the emergence of the efficient market hypothesis in the mid-20th century, which posits that market prices already reflect all available information, making it difficult for any investor to consistently achieve superior returns without taking on additional risk.

Reports like the Morningstar Active/Passive Barometer, first published in 2002, have provided regular data illustrating the challenges active managers face. These reports consistently show that a significant percentage of actively managed funds underperform their passive counterparts over various time horizons, especially when considering fees. For example, Morningstar's U.S. Active/Passive Barometer report for year-end 2024 indicated that less than one-fourth of active funds outperformed over the past decade⁵. Similarly, the S&P Indices Versus Active (SPIVA) scorecard also frequently highlights that a majority of active funds fail to beat their benchmarks over extended periods⁴. This persistent underperformance reinforces the relevance of understanding and quantifying active shortfall risk in investment analysis.

Key Takeaways

• Active shortfall risk measures the likelihood or extent to which an active portfolio underperforms its benchmark.
• It is a core concern for investors considering actively managed funds due to potential for lower net returns.
• The risk is influenced by management fees, transaction costs, and the manager's skill.
• Understanding active shortfall risk helps in setting realistic expectations for actively managed investments.
• Historical data often demonstrates that a significant number of active funds fail to consistently outperform their benchmarks.

Formula and Calculation

The calculation of active shortfall risk is not represented by a single, universally standardized formula, as it is more of a conceptual measure of probability or magnitude. However, its assessment often involves analyzing the active return of a portfolio relative to its benchmark over time. This can be expressed as:

When evaluating active shortfall risk, one might consider metrics such as the frequency with which the active return is negative, the average magnitude of negative active returns, or the tracking error of the portfolio. Tracking error measures the volatility of the active return, providing insight into the consistency of performance relative to the benchmark. A higher tracking error can indicate greater potential for both outperformance and underperformance, thus contributing to active shortfall risk.

Interpreting the Active Shortfall Risk

Interpreting active shortfall risk involves understanding not just whether an active manager beats their benchmark, but by how much they might fall short, and how consistently. A high active shortfall risk suggests that the manager's decisions, including their security selection and asset allocation calls, are prone to leading to underperformance. For instance, if a fund consistently delivers negative active returns, even if small, it indicates a persistent active shortfall.

Investors evaluating active shortfall risk should look beyond short-term fluctuations. Long-term underperformance, especially after accounting for all fees and expenses, points to a significant active shortfall risk. It indicates that the additional costs associated with active management are not being justified by superior net returns. In essence, the lower the active shortfall risk, the greater the likelihood an active manager can meet or exceed their investment objective.

Hypothetical Example

Consider an investor, Sarah, who has a portfolio managed actively, aiming to outperform the S&P 500 index. Her portfolio starts with an initial value of $100,000.

Over a year, the S&P 500 returns 10%. Sarah's actively managed portfolio, however, returns 8%.

Calculate the Active Return:
Active Return = Portfolio Return - Benchmark Return
Active Return = 8% - 10% = -2%

In this hypothetical example, Sarah's portfolio experienced an active shortfall of 2% for the year. This means the active manager's decisions led to a return that was 2 percentage points lower than the benchmark. If this underperformance persists over several years, it would indicate a significant active shortfall risk. This also highlights the importance of considering the impact of fees on net returns, as these expenses further erode any potential outperformance. An investor should also consider the portfolio's risk-adjusted return when evaluating such outcomes.

Practical Applications

Active shortfall risk is a crucial metric in investment analysis and fund selection, particularly for institutional investors, financial advisors, and individual investors who consider actively managed funds.

1. Fund Manager Due Diligence: Investors use active shortfall risk to assess the competency of a fund manager. A history of consistent active shortfalls raises questions about the manager's ability to generate alpha and justifies higher fees.
2. Performance Measurement: It serves as a more nuanced measure of performance than simply looking at gross returns. By comparing an active fund's performance against a relevant, passive benchmark, investors can determine if the manager is truly adding value or merely riding market trends. Data from sources like the Morningstar Active/Passive Barometer and SPIVA scorecard frequently show that many active funds struggle to beat their benchmarks over longer periods, reinforcing the relevance of this analysis², ³.
3. Investment Policy Statements: In creating an investment policy statement (IPS), investors might specify acceptable levels of active shortfall or conditions under which an actively managed strategy would be re-evaluated.
4. Portfolio Construction: Understanding active shortfall risk helps in portfolio construction by enabling investors to decide on the appropriate blend of active and passive strategies. If active shortfall risk is high for a particular asset class, a greater allocation to passive funds might be warranted.

Limitations and Criticisms

While active shortfall risk provides valuable insights, it comes with several limitations and criticisms:

• Benchmark Selection: The accuracy of assessing active shortfall risk heavily depends on the appropriateness of the chosen benchmark. An unsuitable benchmark can inaccurately portray an active manager's performance. For instance, if a manager targets small-cap growth stocks but is benchmarked against a broad market index, an active shortfall might not genuinely reflect underperformance within their specific investment universe.
• Time Horizon: Short-term active shortfalls may not be indicative of long-term performance. Market fluctuations and specific investment cycles can lead to temporary periods of underperformance, which may eventually reverse. Evaluating active shortfall risk over a sufficiently long time horizon (e.g., 3, 5, or 10 years) is crucial to mitigate this issue.
• Fees and Costs: Active shortfall risk inherently accounts for fees and costs, as active return is typically calculated net of these expenses. However, the magnitude of these fees themselves is often a significant driver of shortfall. Higher fees make it more challenging for active managers to outperform, even if their gross returns are competitive. As noted by financial researchers and investor advocates like those in the Bogleheads community, lower fees are often a more reliable predictor of long-term investment success¹.
• Managerial Style Drift: An active manager might deviate from their stated investment style or process, leading to a disconnect with their chosen benchmark and a perceived active shortfall that is more a result of style drift than genuine underperformance within their intended strategy.
• Luck vs. Skill: Distinguishing between genuine skill and mere luck in investment performance is challenging. A period of outperformance might be due to favorable market conditions rather than superior managerial skill, and conversely, a shortfall might be due to temporary headwinds.

Active Shortfall Risk vs. Tracking Error

Active shortfall risk and tracking error are related but distinct concepts in finance, both pertaining to the performance of actively managed portfolios relative to a benchmark.

While active shortfall risk focuses on the undesirable outcome of underperformance, tracking error provides a measure of the volatility associated with pursuing active returns. A portfolio with a low tracking error typically hugs its benchmark closely, implying a lower active shortfall risk unless the fees are prohibitively high. Conversely, a high tracking error means the portfolio's returns can diverge significantly from the benchmark, leading to either substantial outperformance or a notable active shortfall.

FAQs

What causes active shortfall risk?

Active shortfall risk arises from a combination of factors, including management fees and operating expenses, transaction costs incurred through frequent trading, adverse market timing decisions, poor security selection, and the inherent difficulty of consistently beating efficient markets. These factors collectively erode potential gross returns, leading to a net underperformance against a benchmark.

Can an actively managed fund have a low tracking error but still exhibit high active shortfall risk?

Yes, theoretically. If an actively managed fund has very high fees and expenses, it could closely track its benchmark (resulting in a low tracking error) but still consistently underperform after costs, leading to a high active shortfall risk. However, typically, a low tracking error suggests the fund is not deviating much from the benchmark, which would usually lead to low active shortfall risk unless fees are exceptionally high.

How can investors mitigate active shortfall risk?

Investors can mitigate active shortfall risk by carefully selecting active managers with a proven long-term track record of outperformance after fees, opting for funds with lower expense ratios, diversifying across multiple active managers or strategies, and considering a core-satellite approach that combines passive core holdings with active satellite investments. Furthermore, focusing on long-term investing can help smooth out short-term underperformance.

Is active shortfall risk only relevant for equity funds?

No, active shortfall risk applies to any actively managed investment strategy that aims to outperform a specific benchmark, regardless of the asset class. This includes actively managed bond funds, alternative investments, and multi-asset funds, all of which face the challenge of outperforming their respective benchmarks after accounting for costs and management decisions.

Does active shortfall risk mean active management is always bad?

Not necessarily. Active shortfall risk highlights the challenge of active management and the statistical likelihood of underperformance for many active funds. However, some skilled active managers do consistently outperform their benchmarks over long periods. The key is identifying those managers, which is a difficult task. For many investors, the consistent underperformance of a large percentage of active funds makes passive investing a more reliable strategy for achieving market returns.