Active Management – Fooled By Conviction by S&P Global
H/T Barry Riholtz
“Our destiny is frequently met in the very paths we take to avoid it.” — Jean de La Fontaine — Fable 16
In order to improve performance, advocates of active management have begun to argue that managers should focus exclusively on their best ideas, holding more concentrated portfolios of securities in which they have the highest confidence. In contrast, we argue that if it becomes popular, such “high conviction” investing is likely to:
- Increase risk,
- Make manager skill harder to detect,
- Raise asset owners’ costs, and
- Reduce the number of outperforming funds.
[drizzle]These arguments apply even if we accept that security selection skill is prevalent among active managers. Concentration only makes sense if managers have a particular type of skill, and this skill must be intrinsically rare.
Fooled By Conviction – Introduction
Most active managers fail most of the time, at least if we regard their underperformance of passive benchmarks as indicative of failure.1 This fact is so well known and widely demonstrated that even staunch advocates of active management acknowledge it.
What remains in dispute is what active managers should do to improve performance. Some argue that active management fails because it is not active enough. Active managers, it’s said, are reluctant to deviate too much from a passive benchmark, knowing that their performance will be compared to it. They hold positions they don’t find especially attractive, simply to ensure they do not fall too far behind their peers. The proposed remedy for such “overdiversified” portfolios is for managers “to invest with high conviction, concentrating capital in the ideas they think are most likely to deliver strong long-term returns.”
This is not a completely new argument; one of the putative remedies for managers embarrassed by their performance during the technology bubble of the late 1990s was to place more emphasis on their “best ideas.” Yet the modern argument has attracted greater attention. In part, this is due to recent empirical evidence that managers deviating significantly from benchmarks had outperformed. In another part, the argument for more aggressive positioning from active managers is a natural response to the general trend of lower dispersion among stocks that has emerged since the financial crisis—a phenomenon that has made even skillful stock-picking activities less rewarding.
Suppose that active portfolios become substantially more concentrated in each manager’s “best ideas.” What might the consequences be?
First Consequence: Risk Is Likely To Increase
Other things equal, more securities mean more diversification. Exhibit 1 makes the point using the S&P 500, comparing the average volatility of the index to the average volatility of its components.
Between 1991 and May 2016, the average volatility of returns for the S&P 500 was 15%, while the average volatility of the index’s components was 28%.7 The difference between one stock and 500 is an extreme case, but it serves to illustrate the obvious point: if the typical active manager owns 100 stocks now and converts to holding only 20 or so, the volatility of his portfolio will almost certainly increase.
In a world where all active managers concentrate their portfolios, fund owners face a dilemma. Asset owners have been known to grouse about the quality of active managers’ performance, but we have yet to identify one who has expressed a desire to hold a riskier portfolio. For the asset owner, then, there are two possible ways to manage the increase in portfolio risk.
The first is for asset owners to retain the same number of active managers as before, but reduce the proportion that is actively managed. If overall pension fund volatility is to remain the same, the assets taken from active managers have to be put into some other—putatively less risky—investment. This is not in itself objectionable, but it does force asset owners to reduce the proportion of their allocation that they expect to outperform.
Alternatively, asset owners who wish to retain the proportion of their portfolio that is entrusted to active managers must hire more of them. Instead of using 20 mangers each with 100 stocks, for example, a fund might achieve the same risk profile by using 100 concentrated managers, each holding 20 stocks. As well as the considerable additional time and expense required on the part of the asset owner,8 this produces a major logical inconsistency. In the name of conviction, managers who pick stocks are told to pick fewer stocks. As a consequence, asset owners who pick managers may be required to pick more managers.
Thus, as asset owners cast a wider net to mitigate the now-higher risk of their incumbent managers, the increased concentration of active funds might prove advantageous only to consultants supporting the expanded effort to secure sufficiently diversified active exposures.
Second Consequence: Management Skill May Be Harder To Detect, And Less Likely To Matter
Some managers may be skillful, but none are infallible. A manager who is skillful but not infallible will benefit from having more, rather than fewer, opportunities to display his skill. A useful analogy is to the house in a casino: on any given spin of the roulette wheel, the house has a small likelihood of winning; over thousands of spins, the house’s advantage is overwhelming.
Exhibit 2 illustrates the concept. In a coin-flipping game with a biased coin, we win the game if more than one-half of our tosses come up heads. In one case, the coin has a 53% chance of heads and in the other, the coin has a 55% chance of heads. As the exhibit shows, the chance of winning grows as the number of tosses rises and, for any number of tosses, the chance of winning is higher with the more favorable coin. However, if the number of tosses varies between the two coins, at some point, it is preferable to have a worse coin and more tosses.
The analogy to security selection is straightforward: instead of flipping a coin, a manager picks stocks with a given probability of outperforming the market. If more than half of his picks outperform, the manager “wins” the game. The more picks he makes, the more likely it is that his skill dominates his luck. As with the coin-flipping game, for a constant number of stocks, a more skillful manager is more likely to outperform than a less skillful manager. But if the number of picks varies, an asset owner may be more likely to outperform with a less skillful manager who buys more stocks.
A manager with below-average skill, in this analogy, is also flipping a biased coin, but his coin has less than a 50% chance of coming up heads. Ironically, this manager has a better chance of winning the game the smaller the number of tosses (just as a skilled manager has a better chance the more he tosses). Concentrating portfolios, in other words, makes it more likely that good managers will look bad, more likely that bad managers will look good, and more likely that asset owners’ decisions will be informed by luck rather than skill.
Third Consequence: Trading Costs May Rise
It is not certain whether the proponents of higher concentration would prefer to see smaller individual fund sizes, or whether