High conviction strategies find alpha in ultra-efficient markets

Most investors have thrown in the towel on active management within the US equity market, assuming that the market is too efficient and that low cost passive representation is sufficient for client exposure. While it is difficult to dispute the poor after-fee performance of the average US equity manager, we have found pockets of success within the US equity market representing proven skill in a highly competitive space. 

A number of studies suggest managers who build highly concentrated or high active share portfolios have a better chance of providing higher returns. The academic paper that introduced the concept of active share was released in 2009 by Martijn Cremers and Antti Petajisto, namely How active is your fund manager? A new measure that predicts performance. Active share measures the percent of the portfolio that is different from the benchmark index. The authors concluded that mutual funds with high active share demonstrated superior returns compared to managers with low active share. 

Interestingly, the study also showed the share of assets under management for closet indexers (active share below 60 per cent) rose from 1.5 per cent in 1980 to 44.8 per cent in 2003 while assets for active managers (active share above 80 per cent) declined from 42.8 per cent to 23.3 per cent over the same period.

While we do not believe any one measure of a portfolio can be used to identify future outperformance, we have found that high conviction portfolios managed by highly skilled investment professionals have proven successful for our clients.

In seeking active managers we will evaluate those managers on qualitative and quantitative criteria. Qualitative questions include: what is the philosophy and process behind the strategy, who are the key decision makers, what is their background, experience, skill set, how are they motivated and compensated? 

While a qualitative assessment is critical to identifying skilled managers, no investment firm clears our due diligence process without a proven track record of success. Our quantitative analysis provides a proof statement that a manager’s process is sound, diligently followed and provides clients with a risk-adjusted return that is highly competitive to peers.

SIMPLE STRUCTURES

Interestingly, concentrated managers often share a number of quantitative and qualitative attributes. From a qualitative perspective, concentrated managers are often found at smaller firms, or boutiques within larger firms, and have relatively simple business structures with fewer products. They are typically bottom-up stockpickers and have a longer-term investment horizon. They tend to have deep research processes where they build a high level of conviction in their companies. In meetings, these managers often tell us they do not need lots of great investment candidates, they only need a few. That said, they can have very different approaches and may be growth, value, quality or contrarian in their style. 

In terms of quantitative measures, these managers typically have high active share, healthy and sometimes high tracking errors and low turnover – tied to these managers’ high conviction and longer time horizons.  We specifically target those managers that also have high risk-adjusted performance results. 

Importantly, we do not focus on a point-in-time evaluation. Rather, we analyse these statistics over as long a track record as the manager can provide and over rolling time periods. We must evaluate these characteristics over time to ensure they are stable. This process allows us to become comfortable that the manager is using a disciplined process that does not lead to style drift over time.

Concentrated strategies can provide strong potential to outperform benchmark indices over a full market cycle, but also can add significant tracking error risk to the mandate. We therefore often match these managers with strategies that have lower tracking error, including risk-factor strategies (which Northern Trust calls “engineered equity”) or passive index strategies that reduce the risk of significant relative underperformance during short to intermediate time periods. 

A combination of these strategies in a core/satellite structure within our US equity mandates also has the benefit of reducing the overall fee for clients.

Identifying highly skilled managers in any asset class can be a challenge. We have found that high conviction strategies, where managers take significant bets away from standard indices, can produce very good results for clients, particularly in what investors perceive as highly efficient markets such as the US equity market. We also realise some clients may not have a long time horizon with respect to evaluating results. And in cases where core or passive investing is inexpensive we recommend combining highly active satellite strategies with core, passive investments.    

Chris Vella is chief investment officer for multi-manager solutions and Mark Meisel is senior investment product manager at Northern Trust Asset Management