High active share and greater portfolio concentration are hot topics within active equity management. Together they constitute what is commonly referred to as “high conviction” investing. It is generally accepted that—all other things being equal—both higher active share and greater portfolio concentration are not merely desirable, they are essential for delivering benchmark-beating results. Belief in this duo is such that increasing both is commonly suggested as a precondition for success.
Numerous academic papers describe the positive relationship between high conviction and generating excess returns or what is commonly referred to as alpha. The research also argues that the presence of high conviction is not just correlated with alpha but is in fact predictive of future outperformance. Integrating these research findings together with their own internal needs, asset owners and third-party asset allocators (e.g., multi-family offices and outsourced chief investment officers)—together referred to herein as asset owners/allocators—increasingly are challenging what they perceive as excessive diversification within active equity portfolios and routinely pushing for higher conviction. For their part, many managers now promote high conviction as a key component of their portfolio management/construction regimes—and presumably likelihood of delivering strong results.
While it is a fact that high conviction is associated with a number of successful equity funds, it is by no means universally beneficial. To the contrary, 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. How can this be? The answer lies not in intent but in method—or more precisely how higher conviction is implemented.
In our new white paper Active Share and Portfolio Concentration – Metrics Not Prescriptions, we briefly review the struggles plaguing active management. We then consider the origins and usefulness of the high conviction movement, describing its shortcomings as well as common reasons for poor implementation. We present five case studies of actual portfolios engaged in high conviction with mixed results and describe new metrics for quantifying skill and investment process which substantially enhance the ability to identify outperforming managers. Finally, we conclude with a clear message to asset management companies and their clients that adoption of the revised best practices as outlined is essential to both the effective allocation of capital as well as continuation of a vibrant active management industry.
Michael A. Ervolini, CEO, Cabot Investment Technology, Inc. a FactSet Company, and Matthew Gadsden, Partner and Head of Global Equities Research, JANA Investment Advisors, contributed to this article.
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