Conviction Adds Clarity In Complex Markets by Sharon Fay, Dianne Lob and Nelson Yu, AllianceBernstein
It’s never easy to know exactly how an active manager generates returns in complex equity markets. High-conviction strategies can provide greater transparency about the sources of returns—and help create more consistent equity outcomes.
Part of the appeal of passive investing today is driven by market innovations. In traditional active portfolios, the sources of returns were often a gray area (Display). Investors couldn’t always tell how much of a manager’s returns were coming from the market, factor exposures or manager skill.
Today, investors can buy two components of equity returns—broad market exposure and factor exposure—fairly cheaply, through index funds and smart-beta solutions. However, there could be an opportunity cost for choosing these low-conviction options. With returns across asset classes likely to be much lower in the coming years than in the last three decades, we think that forgoing returns from stock selection for the perceived simplicity of passive solutions could leave investors far short of their goals.
Asking the Right Questions
High-conviction equity strategies offer another way. As the right side of the diagram above indicates, high-conviction equities allow investors to make full use of the equity market while also making it much easier for investors to know how much of a strategy’s returns are actually being derived from a manager’s research insights or other expressions of conviction.
This template can help investors ask portfolio managers the right questions about the source of their skill and conviction. It can also help investors gain more clarity about how a portfolio will perform in different environments, as we will demonstrate in a forthcoming blog.
Conviction Takes Many Forms
Conviction is more than just high active share or low name count. Active share and concentrated portfolios are important expressions of high-conviction investing. But they don’t tell you whether a manager has any skill at all. Portfolios that differ from the benchmark or hold small numbers of stocks might have large positions that don’t do well and drag down absolute and relative returns.
Our definition of skilled, high-conviction investing is much broader. First, high-conviction portfolios must have a clear investing philosophy backed by strong research capabilities; this helps ensure that a portfolio manager isn’t just taking outsized positions arbitrarily. Second, a disciplined process is crucial. And third, a high-conviction portfolio must differ meaningfully from the benchmark.
When viewed through this lens, conviction can take many forms. It might be an emerging-market equities manager with a clear growth philosophy. Even more defensive portfolios focused on dividend-yield stocks or stocks with lower volatility characteristics can be considered high-conviction strategies if they execute a clear, consistent philosophy. These approaches can all reflect conviction—and they can be implemented in diversified portfolios with high active share or concentrated portfolios with a small number of stocks.
Our research shows that different types of US high-conviction equity managers have a solid track record versus the S&P 500 Index and passive factor indices, and have delivered strong risk-adjusted returns over time. We believe that high-conviction equities can be used for a variety of targets, from reducing downside risk to generating income to capturing more upside in rising markets (Display).
Equity investors today face a blinding array of choices—and big dilemmas. Should you channel increasing portions of an equity allocation toward passive solutions? How can you plan appropriately for an extended period of relatively low returns from all asset classes—and still meet your long-term objectives?
To make an equity allocation work harder, the portfolios that you pick matter. We believe that rethinking how high-conviction strategies are chosen can help investors ensure that money spent on active management is deployed effectively—and appropriately—for their individual goals.
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.