Active managers are increasingly being swept up in the high-conviction investment craze that follows the logic that portfolio managers should only invest in their best ideas. Doing so should result in better performance, but a new study from Cabot Investment Technology and JANA Investment Advisers finds that isn’t always the case, reports Institutional Investor.
High-conviction, concentrated strategies are being employed in greater numbers lately by asset managers who are aiming to beat index performance, in a bid to lure more investors away from passive investing. However, there are many pitfalls when it comes to launching funds with this type of strategy.
Academic research in the past has shown a positive correlation between conviction and high returns, but that is when a sampling of hundreds to thousands of portfolios are studied en masse, explained Michael Ervolini, founder and CEO of Cabot and co-author of the report. On an individual portfolio manager basis, the positive results tend to be difficult to replicate, and sometimes even lead to a decrease in ROI.
There are a lot of factors to consider in this type of portfolio creation and management. “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 said.
By reducing the number of investments carried within a strategy and concentrating the portfolio, these individual asset managers are opening themselves up to risk in an area they are potentially less comfortable in, as well as picking fewer high-performing securities.
The report gave the example of a portfolio with 50 assets and a 60% turnover rate in which the portfolio manager only needs to have a success rate of half winners compared to the total amount of securities bought in order to beat the 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),” the report said.
Other potential missteps by individual portfolio managers found in the study might be selling too slowly, or else decreasing turnover because of potential attachment to favored stocks in their concentrated funds. On the other end, these same portfolio managers could be falling victim to adverse selection in which they make the wrong judgement calls because of pressure, or else they may not entirely understand their buy process.
“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.
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