It’s hard to argue with the thesis that active managers who only invest in their best ideas should perform better.
But high-conviction, concentrated strategies – which active asset managers are increasingly turning to in a bid to beat benchmarks and win back index fund investors – present their own pitfalls and can lead to a mixed bag of outcomes.
A new study from Cabot Investment Technology (formerly Cabot Research) and JANA Investment Advisers, argues that high-conviction approaches to portfolio construction aren’t a cure-all for active managers. Allocators are pushing managers to focus on stock picks in which they have the highest confidence and managers in turn are touting that their investment processes incorporate this thinking and is a signal that they’ll outperform in the future, according to the report. Cabot is owned by FactSet, a financial data and analytics company.
The research, called “Active Share and Portfolio Concentration: Metrics not Prescriptions,” covers what it calls the high-conviction movement, its shortcomings, some of the problems when implementing the strategy, and examples that have led to mixed results. It also includes recommendations for allocators, including new metrics to quantify the investment skills of managers.
“Simply increasing the active weight of a few positions and/or reducing the number of positions held can and does lead to lower performance with startling regularity,” the report argues.
Michael Ervolini, founder and CEO of Cabot, and the report’s co-author, agrees that many academic research studies have found a positive relationship between conviction and excess returns. But that’s when hundreds or thousands of portfolios are studied in aggregate, he pointed out. It’s not clear that an individual portfolio manager can effectively implement the strategy going forward in a way that consistently increases returns. In some cases, it decreases returns.
“For some managers that have been running a diversified portfolio, let’s say 50 names, to get down to 30, they have to change what they’re doing. It’s as if you were going to change your golf or tennis swing. You could make it better or you could make it worse,” Ervolini told Institutional Investor.
To combat competition from passive strategies, active managers have been turning to novel ideas to generate better returns or to highlight the existing value that active managers can offer. Managers are doing everything from making significant investments in data science to developing alternative ways for investors to determine whether an actively managed fund or their portfolio is succeeding or not.
It’s not surprising, then, that asset managers and allocators have turned to a body of academic research that has found a strong relationship between managers in aggregate that invest in securities with “high conviction” and their ability to deliver high returns relative to an indexed portfolio.
“The research also argues that the presence of high conviction is not just correlated with alpha but is in fact predictive of future outperformance,” wrote Ervolini and his co-author Matthew Gadsden, a senior consultant and head of global equities at JANA. To assess whether a portfolio is managed in a high conviction way, institutional investors and consultants use several metrics, one of the most popular being active share, essentially a measure of how different a portfolio is from a benchmark.
Ervolini said many of the problems with high conviction investing arise from how the strategy is implemented.
For example, when portfolio managers start reducing the number of stocks they hold, they may choose fewer winners. The report describes a portfolio of 50 positions with a 60 percent turnover rate. The portfolio manager only has to have a success ratio of 1/2 — the winners compared to the total number of securities that have been bought — to beat their benchmark. “Now if under a high conviction regime, the manager is selecting only 8-12 new positions each year, it is possible that the proportion of winning names can go down (so that the success ratio drops to 1/3),” according to the report.
That’s because of behavioral biases. “It’s adverse selection,” he said. “You’re going through an uncomfortable experience, you can choke, you might just take more of the best ideas out.” Adverse selection can also arise because portfolio managers don’t fully understand their so-called buy process.
Ervolini said another example is when portfolio managers attempt to increase their active share, they may make changes too slowly. “These are big changes, and you might drag your feet. But what you could wind up doing is following a great stock as the price goes up.”
Other pitfalls the research identifies is portfolio managers increasing their trading — rarely a lucrative activity — now that some of their time is freed up because they’re following fewer names. Managers may also significantly reduce turnover in their portfolio, perhaps as they get attached to certain securities in a more concentrated fund.
That lower turnover can be dangerous for investors. According to the analysis, portfolio managers may “buildup …so-called dead money,” or investments that return nothing or even produce losses, reducing overall returns.
“High conviction might be a good target for many managers, but the process of getting there is fraught. There’s so much noise in the academic arena about this that you end up believing it can fit anybody. But it’s hard to retool your processes, both practically and emotionally,” said Ervolini.