Identifying Skill and High Conviction
Investing in equity markets requires confidence. It takes guts to invest in a Chinese Internet company when the world’s biggest economy is slowing down. You need to be self-assured to buy into a drugmaker whose growth prospects depend on an unproven treatment. And when oil prices are tumbling, taking a position in a US energy group warrants more than a measure of bravado.
But without skill, confidence isn’t worth much. In the examples above, and countless more, it takes skill based on years of experience to develop a differentiated view to underpin high conviction. Today, many investors have moved their equity allocations away from active approaches to index strategies because they’re skeptical about stockpicking. In this paper, we show how investors can identify skilled high-conviction managers and create effective combinations to source consistent, long-term equity returns.
Today, passive approaches are very popular. Many investors have lost faith in diversified active portfolios because of their disappointing and inconsistent performance, as well as their high fees relative to passive peers. But investing in an index alone could leave investors short of their goals. With market returns likely to be much lower in the coming decade, we believe that beating the market matters more today.
There’s another way to seek alpha in equity portfolios. It starts by rethinking how different types of active strategies are chosen and deployed—and by focusing on true conviction. From 2004 to 2014, skilled high-conviction equity managers outperformed the S&P 500 Index by a significant margin (Display below), gross of fees. And strong information ratios indicate attractive risk-adjusted returns. The outperformance ranged from 1.6% and 1.9% in the value and dividend-yield categories, respectively, through 3.0% and 3.2% in the momentum and high active share categories, respectively. These are meaningful premiums to the benchmark, even after fees, which are, of course, the critical issue for investors.
With market returns likely to be much lower in the coming decade, we believe that beating the market matters more today.
In our view, skilled high-conviction stock pickers have a clearly defined angle on the market, built on knowledge, judgment and experience. When these attributes are rigorously applied to an equity portfolio, all of the components of equity market returns can be captured to deliver powerful results.