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For Better Investment Results, Concentrate

Updated: May 19, 2022

As the Financial Times’ John Authers rightly points out, “active share” – the portion of a fund that differs from its benchmark – should never be used in isolation to assess funds (“Active fund managers are closet index huggers,” March 12). The notion that there exists a simple measure to predict performance is clearly absurd. Furthermore, whether or not it should be used in conjunction with other tools is also contentious.

"Alpha generation is after all a zero-sum game"

Research by Martijn Cremers, professor of finance at the University of Notre Dame, and Antti Petajisto, a portfolio manager at BlackRock and former assistant professor of finance at Yale, found that, net of costs, high active share funds on average performed better than index funds, which in turn performed better than low active share funds. This was certainly an interesting conclusion, but why should it be true that high active share funds tend to perform well?

Ross Miller, finance professor at the State University of New York, devised a clever way to demonstrate why closet index funds were a bad idea. His insight was that any fund could be divided into two parts: a passive portion that correlated 100 per cent with the benchmark and an active portion that was 0 per cent correlated. By assigning typical passive fund fees to the passive portion one could then calculate the effective fee (the actual fee less the passive fee) that one was paying for the active portion.

In the case of the benchmark huggers, the active fee was so high – in some cases as high as 7 per cent – that the chances of producing sufficient alpha, or excess returns, to cover it as well as leaving a big chunk for unit holders were negligible. High active share funds are therefore the ones giving themselves a chance to produce sufficient alpha, but why do they also tend to succeed in this endeavour?

There are essentially two ways to get a high active share: run a fairly concentrated portfolio, taking little notice of benchmark constituent weights, or run a diversified portfolio full of stocks that are not in the benchmark. There are few if any funds that fall into the latter category, so the argument is really about why concentrated portfolios are a good idea.

Skill, and thus good performance, is about first spotting and then taking advantage of price anomalies. It is other investors – “the market” – that create the price anomalies in the first place, so good performance will always be at the expense of others. Alpha generation is after all a zero-sum game.

The behavioural trait known as herding from time to time takes prices to levels that, with analysis, can be declared cheap or expensive. Such mis-valuations – or mispricings – can be tiny ones that correct in a few seconds or hours, or bigger ones that correct over a few years. Jim Simons, founder of hedge fund Renaissance Technologies, uses a very powerful and very quick computer to spot the tiny ones before anyone else. Others are more interested in the longer ones.

Longer-term price anomalies are well documented. Sanjoy Basu, former professor of finance at McMaster University in Ontario, and Robert Shiller, professor of economics at Yale, found that stocks with high dividend yields outperform stocks with low dividend yields. US economist Eugene Fama and Kenneth French, professor of finance at Dartmouth College, showed that this predictability increased with time: while over one year the dividend yield explained 15 per cent of the variation in excess returns, over five years it explained 60 per cent. It seems that investors systematically overestimate the extent to which growth stocks will grow.

Since it is growth stocks that tend to make the headlines with stories of expansion and acquisition, it is hardly surprising that this attention can cause overvaluation. Corporate governance is another factor that gets systematically mispriced. Paul Gompers, professor of business administration at Harvard, Joy Ishii, assistant professor of finance at Stanford, and Andrew Metrick, professor of finance at Yale, found that the stocks of companies with good corporate governance outperformed those with poor corporate governance by 8.5 per cent per annum. Given that the well-governed companies were ones that had lower levels of capital expenditure and made fewer acquisitions, this anomaly is perhaps also explained by an interest in newspaper headlines.

Armed with this evidence, and having identified potential winners, one then has to decide how much to commit to each. Here we turn to mathematician John Kelly and his work on horse betting. He devised a very simple formula, known as the Kelly Criterion, to determine what percentage of your purse to bet on a particular horse, the equivalent perhaps of how much of your portfolio to invest in a particular stock. If the market odds of a horse winning were 50 per cent but you had an edge of some sort and believed its chances were 55 per cent, the formula said you should bet 10 per cent of your purse to maximise your winnings.

The empirical findings with respect to dividend yields and corporate governance are so strong that one should consider them to represent a considerable edge. While it is impossible to put a number on precisely what that edge might be, the evidence strongly supports the case for putting 10 per cent in a thoroughly researched, well-governed, high-yielding stock, not 1 per cent. Perhaps managers who construct concentrated portfolios are on to something after all.

Published in the Financial Times

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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