Active managers may be sabotaging themselves by not playing their strongest stock-picking suit
For active managers, the need to come back from their 10-year losing streak to passive investing is clear. What’s not so clear is how they can do that.
It comes down to a question of why they’ve lagged in performance. Is it because of their high fees, as asserted by cost-conscious investors and numerous investment-research firms? Is it because stock-pickers just can’t beat the market consistently enough? Or is it something else?
It’s a difficult question to answer, but a new study of equity mutual funds seeks to answer that by focusing on one aspect of manager decision-making: conviction, or a manager’s commitment to different subgroupings of equities within a given fund.
“We conducted a multi-year analysis that covered 114 US equity mutual funds from 57 fund families and evaluated more than 400,000 individual rolling one-year performance periods,” said Alexey Panchekha, co-founder of Turing Technology Associates, in a piece published by the CFA Institute. “[W]e measured the scale of overweight and underweight positions rather than the raw size of the holdings, which tends to be biased by the benchmark weightings.”
Panchekha said they distinguished among three primary categories of stock positions — High-Conviction Overweight, Underweight, and Neutral-Weight — by measuring real-time, daily mutual fund holdings and weights, and rebalancing each group every 14 days.
They then looked at the success rate of each category relative to their benchmark — a 50% success rate indicates market-neutral returns — over rolling one-year periods, and the average annual excess return of those rolling periods.
“The High-Conviction Overweights, composed of the managers’ best ideas, is the only category that delivers stock selection alpha,” he said. The category reportedly achieved success rates of 84% gross of fees; after applying a theoretical 85-bp fee, the success rate fell to 74%.
Meanwhile, Underweight and Neutral-Weight stock holdings showed a success rate of 50% gross of fees, meaning they did as well as a pure-beta portfolio. After fees, the success rates fell markedly to 43.8% for Underweights and 0% for Neutral Weights.
“As the sole source of excess return, High-Conviction Overweights need to be the main emphasis of all actively managed portfolios,” Panchekha said. But based on their research, the average fund manager assigned High-Conviction Overweight Stocks an overall portfolio weight of 55%. Underweights and Neutral Weights, effectively, acted as a “Beta Anchor” that weighed on the alpha from High-Conviction positions.
He acknowledged that maintaining a market-neutral component in a portfolio can be beneficial: aside from reducing tracking error versus the benchmark, it faces a lower likelihood of relative-performance failure relative to a more highly concentrated portfolio.
“Nevertheless, any risk-management benefit is offset by a significant performance penalty,” he noted. “While it is industry convention to blame these outcomes on higher fees, our research suggests that fees are only a secondary contributor.”
