New Paths To More Consistent Equity Alpha by Dianne Lob and Nelson Yu, AllianceBernstein
Every investor approaches the equity market with a different goal—and faces a wide array of portfolios to choose from. Our research suggests that high-conviction equity strategies can be combined to achieve more consistent outcomes with better risk-adjusted returns.
For some investors, the memory of the 2008 financial crisis evokes a sense of insecurity, so limiting downside risk is their highest priority. Others may have a higher risk tolerance and will focus on beating the benchmark by a wide margin—even if the return path is more volatile. And today, many investors want to find better ways to source consistent alpha from erratic markets.
Investors often ask how many portfolios are needed to generate a more consistent pattern of returns. The answer really depends on the kind of conviction strategies used in an equity allocation.
Different types of high-conviction strategies are typically associated with each type of outcome. In fact, all these approaches can work well for diverse investor goals. But using just a single type of high-conviction approach isn’t always the best way.
The Concentrated Conundrum
Take concentrated equities as an example. Concentrated equities are an integral part of a high-conviction tool kit. Yet they tend to have higher levels of tracking error, so the magnitude by which they can outperform or underperform a passive index is larger. It’s also harder to predict their correlations to their peers. So how can you reduce risk in a package of concentrated equities?
In our example, we started by looking at a single concentrated portfolio, ranking at the 30th percentile, with a very high tracking error of more than 6% (Display). Putting together three concentrated portfolios reduced the tracking error to just above 4%. And it took five concentrated equity portfolios to reduce the tracking error by half, to about 3%.
Concentrated equities play an important role in a high-conviction equity allocation, in our view. They are often less benchmark sensitive, can cushion declines in down markets and manifest the best of stock selection alpha, with low correlation to many other high-conviction strategies. We believe that concentrated approaches are especially effective when they’re based on a differentiated investment philosophy with a clear approach, so an investor knows what’s likely to drive returns.
More broadly, understanding how conviction is expressed in any equity portfolio is the key to getting better results. One advantage of expressing conviction through factors is that investors can get a similar tracking error reduction from fewer managers. To test this theory, it’s important to understand how different strategies perform together.
The first step is to identify strategies with low correlations to one another. In the following example, we’ve created a hypothetical portfolio by combining 30th-percentile performers within high-conviction categories.
Conviction Combinations: Growth and Dividend Yield
Investing in companies that are likely to deliver surprising long-term growth is especially exciting in an era of technological transformation. But growth investors know that volatility can deal a painful blow to short-term performance. In this example, we created a growth-oriented combination by merging a high-conviction growth portfolio with a high-conviction dividend yield portfolio and a high-conviction quality portfolio, with each component allocated a third of the total.
As the Display above shows, there was a wide spread of returns for each individual portfolio from year to year. By creating a growth-oriented combination, however, the dispersion of returns from year to year narrowed significantly. In other words, the offsetting characteristics of each type of high-conviction strategy delivered an explicit diver¬sification benefit; even though the end result for the entire 11-year period was similar, as the box shows, investors’ experience in the growth-oriented combination was much smoother than it would have been with any individual manager. And it took only three managers to achieve a result that required five individual concentrated strategies in the previous example.
There are many ways to express conviction in equity portfolios. By putting skilled, high-conviction strategies together in an equity allocation, we believe that investors can create a powerful package and enjoy a smoother ride through changing market conditions.
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.