No matter where you look in the capital markets, it’s getting harder to find returns. But don’t despair. By taking a fresh look at high-conviction strategies, we believe investors can discover more effective active routes within equity allocations to reach diverse destinations.

Conviction isn’t just a catchphrase for unbridled confidence. It’s about applying knowledge, judgment and experience in an active stock-picking approach with a clearly defined angle on the market. Our research shows that strategies like these can be very effective—if you understand what conviction really is and how it works.

The outlook for returns is sobering. From stocks to bonds to real assets, our forecasts indicate that returns are likely to be below average for all major asset classes over the next decade (Display). In this environment, beating the market by even a small margin of 1% a year can make a big difference.

Yet many investors are settling for much less. Instead of trying to augment returns, passive investing continues to gain popularity. Diversified portfolios that were the lifeblood of many active managers have been largely abandoned.

This shift, of course, reflects genuine concerns about the costs and efficacy of active management. Market innovations have allowed investors to purchase two components of equity returns—broad market exposure and factor exposure—fairly cheaply.

However, there could be an opportunity cost to pay in a world of low returns. In a subdued market environment, high-conviction strategies have an important role to play in an equity allocation to achieve above-benchmark returns. By rethinking how different types of high-conviction strategies are chosen and deployed, we believe that investors can discover better ways to make their equity portfolios work harder. What’s more, identifying strategies that demonstrate persistent conviction can help guide investors toward successful managers.

What Does Conviction Really Mean?

Our definition of high conviction has several layers. First, a portfolio built with conviction must have a clear investing philosophy in order to capture the manager’s proprietary insights. Second, a disciplined process is crucial. Third, a high-conviction portfolio must differ meaningfully from the benchmark. High-conviction managers must also be capable of standing by their research findings, even when faced with big challenges. And yet, they must also have the humility to know when to step back and revisit an investing thesis if circumstances change.

Seen through this lens, conviction can take many forms. It’s much more than high active share, which is commonly considered the linchpin of conviction.

We’ve conducted research on eight types of high-conviction equities, spanning income, value, quality, growth and concentrated approaches. For our study, we defined high-conviction portfolio managers as those ranking in the top 20% of one of these categories in the eVestment US Large Cap Equity universe at least 60% of the time. They also had to have at least three years of reporting characteristics to qualify. From this group, we extracted managers that delivered above-median returns during their reported period. In other words, we looked at portfolio managers that consistently demonstrated commitment and skill for a specific type of investing discipline.

Strong Returns Across Conviction Categories

The results were compelling. From 2004 to 2014, skilled high-conviction equity managers outperformed the S&P 500 Index by a significant margin (Display), gross of fees. The outperformance ranged from 1.6% and 1.9% in the value and income categories through 3.0% and 3.2% in momentum and high active share, respectively. Even when accounting for fees, these are meaningful premiums to the benchmark, backed by strong information ratios, which indicate attractive risk-adjusted returns.

Five of these groups are also represented in passive MSCI factor indices. Here, too, the skilled high-conviction strategies delivered solid results, well ahead of the passive factor indices (Display).

Being Different from the Crowd

These findings are a starting point for a broader discussion about combining high-conviction strategies to achieve a broad range of investing objectives including downside protection, sourcing income, achieving consistent alpha and upside capture. In future blogs, we will show how high-conviction strategies perform in up and down markets and how different combinations can be used to help manage volatility for specific investing needs.

There may not be a silver bullet for a world of lower returns and higher uncertainty. But equally, the passive/active debate is not black and white. In our view, investors can create a combination of passive and active strategies that will achieve their goals by acquiring a deeper—and broader—understanding of how to find conviction in equities.

This blog was originally published in InstitutionalInvestor.com.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.

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