High-conviction strategies — focusing on a handful of stocks in which a manager has a strong, well, conviction — seem all the rage in asset management circles these days. To some extent, this reflects dissatisfaction with active management, which has gained a reputation for being focused on asset gathering while watering down managers’ best ideas. What’s more, the idea of conviction is compelling. After all, who could dispute that asset managers should believe strongly in their portfolios?
With respect to the important substance of the issue, however — how we should evaluate conviction — the discussion has lost its way. The number of holdings in a portfolio has become by far the most prevalent measure, even though it is inadequate and can be gamed. And when applied to quantitative strategies, it’s misguided.
Let’s recognize first that portfolio concentration isn’t a useful measure of anything other than concentration in and of itself. Although a 30-stock portfolio could be distinctive, it might also just represent the 30 largest names in the S&P 500 — a closet indexer with high correlation to the benchmark. So, concentration is a trivial objective. You can get there in any number of ways, and it provides little or no insight into conviction.
What’s the most likely result of concentration? Increased risk. Concentration restricts flexibility in portfolio formation, leading to unintended industry or style exposures. Large positions may require special trading acumen, particularly in less liquid stocks. And, of course, a concentrated portfolio will be more exposed to market forces when — and that is when, not if — unexpected events occur.
For quants, the concentration discussion is even more vexing, because the number of holdings makes no sense in the context of a quantitative investment process. The notion that concentration equals conviction is rooted in the limitations of fundamental investment processes. Evaluating a truly large stock universe requires a herd of analysts — an expensive proposition that indeed might lead to diminution of a firm’s stock selection prowess.
Those limitations are irrelevant for quants. Good quant managers have as much faith in the forecast for their 1,000th stock as for their first. Quantitative managers need to forcefully articulate that we express conviction in a way different from traditional managers. Most do, in fact, run concentrated portfolios — it’s just that we concentrate on characteristics, not stocks.
The priorities of quantitative managers are:
1. Gaining concentrated exposure to the stock characteristics we believe to be most associated with future alpha.
2. Avoiding exposure to sources of uncompensated risk.
3. Implementing portfolios efficiently to limit our market footprint and preserve alpha potential.
Conviction means using all the tools we have at our disposal in an effort to meet those objectives, including a large variety of stocks. A high-conviction quantitative portfolio might easily have hundreds of holdings. Such flexibility allows us to maintain targeted and precise exposure to desired factors while providing the benefits of transaction cost control and reduced uncompensated risk. Limiting the number of holdings can hamper this process.
There is a worry that some managers are promoting highly concentrated portfolios as a way to gather assets in a trendy product area, which is risky but also a seemingly easy way to satisfy investor hunger for manager differentiation. In contrast, quantitative processes are built around the belief that managers should use the maximum amount of relevant information when building investment portfolios.
Let me be clear that my team at Acadian Asset Management is all for conviction! But concentration is a facile and inadequate proxy for demonstrating it. We hope the concentration fad will evolve into a more nuanced discussion centered on the underlying roots of investors’ concerns about active management. Quantitative managers have a specialized set of risk and performance attribution tools to help asset owners understand what conviction means in this context. We owe it to asset owners to be part of this conversation.
Seth Weingram is senior vice president and strategist at Acadian Asset Management in Boston.
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