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The Case For High-Conviction Investing Print E-mail

May 21, 2012

 

By RS Investments

 

Introduction

 

The foundations of active, long-term investing have been challenged in recent years as "short-termism" has pervaded financial markets. Consider that the average holding period of an equity security on the New York Stock Exchange fell to a record-low – seven months – in 2010, down from an average of 25 months in 1990 and well below the recorded high of 97 months in 1953.1 In tandem, volatility has persisted near all-time highs2 reflecting heightened fears about the near-term direction of the market and myriad of uncertainties in the global economy. Record trading volumes in high-velocity ETFs3 also suggest that investors may be focusing on short-term trading strategies as a substitute for a longer-term investment approach.

 

This data suggests a significant lack of conviction among major market participants. In fact, a recent analysis of asset managers found that nearly 80.0% of assets under management in mutual funds are considered to be "low-conviction" strategies, meaning that most actively managed strategies do not differ significantly from a passively managed index.4

 

This white paper dissects recent academic and empirical research that supports the belief that high-conviction active management – the other 20.0% – may be a reliable source of improved risk-adjusted returns across multiple market environments. In fact, two key inputs that define a high-conviction approach, concentration and holding periods, appear to impact the dispersion of returns between top and bottom quartile managers over long time periods. A third measure, active share, may offer professional investors a means to identify high-conviction managers for inclusion in their strategic portfolio allocations.

 

Why Conviction Matters

 

High-conviction active management, characterized by a more concentrated, low-turnover investment approach, may improve investment performance as managers are better able to develop a thorough understanding of portfolio companies and factors that influence their long-term business values. The patience to invest in a company for a longer period of time may also allow ample time for its intrinsic value to be fully reflected in its underlying stock price. In contrast to a high-conviction approach, investing in a large number of companies and buying and selling their shares frequently may limit long-term appreciation potential as managers attempt to capture short-term gains. Such approaches can also add to trading costs, further detracting from returns.

 

The Case for Owning Fewer Names

 

Several academic studies have considered the role of high-conviction portfolios in determining active manager performance. In a 2006 publication titled, Fund Managers Who Take Big Bets, the faculty at Emory University's Goizueta Business School detailed a strong correlation between favorable fund performance and fewer portfolio holdings. Using a universe of over 2,000 funds from a survivorship bias-free mutual fund database, and analyzing over 11,000 time observations from the period of 1976-2003, the author found that high-conviction managers, defined as those who take larger stakes in fewer stocks, outperformed more diversified funds by approximately 30 basis points per month or 4.0% annualized. Their results found that these managers' "big positions outperform the top holdings of more diversified funds," concluding that "evidence suggests that investors may enhance performance by diversifying across focused managers rather than by investing in highly diversified funds."

 

"High-conviction active management, characterized by a more concentrated, low-turnover investment approach, may improve investment performance as managers are better able to develop a thorough understanding of portfolio companies and factors that influence their long-term business values."

 

Further, in a 2008 study, Best Ideas, researchers at Harvard Business School, London School of Economics, and Goldman Sachs Group analyzed monthly stock returns and quarterly fund holdings data for U.S. equity mutual funds over the period 1991-2005. The authors found that active equity fund managers' highest-conviction investments outperformed the broad U.S. Stock Market, as well as other stocks held by those funds, by 1.0% to 4.0% per quarter. The study concluded that many active managers possess skill with respect to stock picking ability, but that their funds often do not illustrate this skill because managers are reluctant to construct high-conviction portfolios that might appear to be at odds with investor perception of risk.

 

Since the active positions relative to a benchmark are those that can provide potential outperformance, these studies suggest that a high-conviction approach may provide a clear path from which a manager can add value. He or she need not own specific companies simply because they have large index weightings, but can instead be selective, investing in stocks that meet stringent investment criteria.

 

The Case for Longer Holding Periods

 

As Alfred Rappaport of the Kellogg School of Management at Northwestern University concludes in his paper, The Economics of Short-Term Obsession, "There is no greater enemy of stock market allocative efficiency than earnings obsession. Alleviating earnings obsession will not eliminate the occasional madness of crowds, but sensible investors looking for excess returns will bet against the madness and hasten the return to sanity. The potential payoff from reducing short-term performance obsession in the investment and corporate communities is substantial."

 

This short-term focus is illustrated by data showing that holding periods for stocks have declined significantly in recent decades. Since many investment managers today buy and sell stocks based upon a company's quarterly earnings, their portfolio holdings may fail to adequately convey the entity's value-creating ability and become susceptible to mean-reverting returns as managers are unable to hone in on the factors that drive long-term business values.

 

exhibit 1 short termism average holding period

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"The potential payoff from reducing short-term performance obsession in the investment and corporate communities is substantial." — Alfred Rappaport, Kellogg School of Management

 

High-Conviction and Risk

 

High-conviction strategies have, at times, been viewed as inadequately diversified due to their more concentrated nature. However, modern portfolio theory suggests that portfolio risk, as measured by standard deviation, may be minimized by investing in as few as 20 holdings.

 

Additionally, the knowledge gleaned on each portfolio company in a high-conviction strategy serves as a critical component of risk management. As Warren Buffett, CEO of Berkshire Hathaway has stated, "Portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he/she must feel with its economic characteristics."

 

exhibit 2 diversification total portfolio risk

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Historical Return and Risk Profile of High-Conviction Active Managers

 

In an effort to segment the active manager universe and assess the historic performance of high-conviction managers, RS Investments performed a proprietary analysis of over 1,000 actively managed funds across market cap and geographic ranges. The resulting data uncovered some potentially meaningful performance differentiation among high-conviction strategies that held the least number of stocks and had the lowest turnover.

 

Across market caps, and in both domestic and international equities, the data leads to several key conclusions:

 

1) Over the last 10 years, high-conviction funds have consistently outperformed both their benchmarks and other actively managed funds.

 

2) Information Ratios which measure unit of return for unit of risk taken by the manager have been greater for high-conviction managers than both active peers and benchmarks over the last 10 years. Information ratios are often used to gauge the skill of managers, measuring the expected active return of the manager's portfolio divided by the amount of risk that the manager takes relative to the benchmark. A higher information ratio implies higher active return, given the amount of risk taken.

 

"Portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he/she must feel with its economic characteristics."

 

– Warren Buffett, CEO, Berkshire Hathaway

 

exhibit 3 high conviction average 10 year annualized return

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exhibit 4 high conviction average 10 year information

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Identifying High-Conviction Managers – The Role of Active Share

 

One indicator of active manager conviction is active share, a measure that calculates the proportion of a manager's portfolio that does not overlap with a benchmark index. In a 2010 study, Active Share and Mutual Fund Performance, Antti Petajisto of the NYU Stern School of Business published data on more than 2,500 U.S. retail mutual funds over a 24-year period, and revealed that managers with an active share of greater than 80.0% who were diversified across holdings and sectors, outperformed their respective benchmarks by roughly 1.14% per year after fees. These managers employed a high-conviction approach, holding fewer stocks for longer periods of time, standing in stark contrast to a "closet indexer" (defined as one with an active share of less than 60.0%) whose holdings closely mirror the benchmark. The study found that high-conviction managers who show strong potential for consistent benchmark outperformance can be identified by two main factors: active share above 80.0% and a diversified stock picking approach.

 

Some active managers and third-party data providers publish active share, which is calculated by determining the difference in weights for all securities in the portfolio relative to the index, summing the absolute differences and dividing by two. Dividing by two ensures that active share results remain between 0.0% and 100.0%. If a portfolio holds none of the index stocks, the active share will equal 100.0%; an index portfolio with holdings identical to the benchmark will have an active share of 0.0%.

 

exhibit 5 illustration of active share

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"One indicator of active manager conviction is active share, a measure that calculates the proportion of a manager's portfolio that does not overlap with a benchmark index."

 

looking ahead high conviction

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Conclusion

 

This paper illustrates through empirical and academic data that a high-conviction investment approach, characterized by the combination of fewer holdings and longer holding periods, has historically led to stronger risk-adjusted performance outcomes. These results suggest that by knowing fewer companies more intimately and holding those companies for longer periods of time, managers may have the potential to improve their portfolio risk-adjusted returns.

 

Investors who are tasked with making strategic, long-term capital allocation decisions face numerous challenges in the current market environment, which is seemingly driven by short-term decision making. As professional investors consider portfolio strategy and long-term allocation decisions, metrics such as portfolio concentration, appropriate diversification of risk, portfolio turnover, and active share may provide useful insight into a manager's value proposition and long-term performance potential.

 

Appendix

 

The two charts below illustrate the analysis of annualized return and risk characteristics (information ratio) of high-conviction active management. The data highlights that managers with more concentrated portfolios and lower turnover outperformed peers over the last 10-year period.

 

exhibit 6 high conviction funds average 10 year

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exhibit 7 high conviction funds average 10 year info

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1 SG Global Strategy Research

 

2 Cirrus Research

 

3 Bank of America Merrill Lynch Fund Flow Data

 

4 Petajisto; "Active Share and Mutual Fund Performance," December 2010.

 

Source: This article was originally published in "The Case for High-Conviction Investing" by RS Investments, (RS White Paper Series Updated Winter 2011), www.rsfunds.com.

 

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