Active Managers’ Investment Skills – Best Ideas

Randolph B. Cohen

Harvard Business School – Finance Unit

Christopher Polk

London School of Economics

Bernhard Silli

Goldman Sachs Group, Inc.

March 15, 2010

Abstract:

We examine the performance of stocks that represent managers’ “Best Ideas.” We find that the stock that active managers display the most conviction towards ex-ante, outperforms the market, as well as the other stocks in those managers’ portfolios, by approximately 1.6 to 2.1 percent per quarter depending on the benchmark employed. The results for managers’ other high-conviction investments (e.g. top five stocks) are also strong. The other stocks managers hold do not exhibit significant outperformance. This leads us to two conclusions. First, the U.S. stock market does not appear to be efficiently priced by our risk models, since even the typical active mutual fund manager is able to identify stocks that outperform by economically and statistically large amounts. Second, consistent with the view of Berk and Green (2004), the organization of the money management industry appears to make it optimal for managers to introduce stocks into their portfolio that are not outperformers. We argue that investors would benefit if managers held more concentrated portfolios.

Active Managers’ Investment Skills – Best Ideas: Introduction

When asked to talk about his portfolio, the typical investment manager will identify a position therein and proceed to describe the opportunity and the investment thesis with tremendous conviction and enthusiasm. Frequently the listener is overwhelmed by the persuasiveness of the passionate presentation. This leads to a natural follow-up question: how many investments make up the portfolio. Informed that the answer is, e.g., 150, the questioner will often wonder how anyone could possess such depth of knowledge and passion for so many disparate companies. Pressed to answer, investment managers have been known to sheepishly confess that their portfolio contains a few core high-conviction positions — the “best ideas” — and then a large number of additional positions which may have less expected excess return but which serve to “round out” the portfolio.

This paper attempts to identify ex ante which of the investments in managers’ portfolios were their best ideas and to evaluate the performance of those investments. We find that best ideas not only generate statistically and economically significant risk-adjusted returns over time but they also systematically outperform the rest of the positions in managers’ portfolios. We find this result across all combinations of specifications: different benchmarks, different risk models, different definitions of best ideas. The level of outperformance varies depending on the specification, but for our primary tests falls in the range one to four percent per quarter.

These findings have powerful implications for our understanding of stock market efficiency. Previous research has generally found that money managers do not outperform benchmarks net of fees. Mark Rubenstein referred to this fact as the efficient-markets faction’s “nuclear bomb” against the “puny rifles” of those who argue risk-adjusted returns are forecastable. Subsequent work has shown quite modest outperformance of around 1 percent per year for the stocks selected by managers (ignoring all fees and costs). We believe this paper is the first to show evidence that the typical active manager can select stocks that deliver economically large risk-adjusted returns.

The paper also has strong implications for the optimal behavior of investors in managed funds. Our findings suggest that while the typical manager has a small number of good investment ideas that provide positive alpha in expectation, the remaining ideas in the typical managed portfolio add no alpha at all. Managers have understandable incentives to include these zero-alpha positions. Without them, the portfolio would contain only a few names, leading to increased volatility, price impact, illiquidity, and regulatory/litgation risk. Adding additional stocks to the portfolio can not only reduce volatility but also increase portfolio Sharpe ratio. Perhaps most important, adding names enables the manager to take in more assets, and thus draw greater management fees. But while the manager gains from diversifying the portfolio, it is likely that typical investors are made worse off. We suggest that investors who put only a modest fraction of their assets into each managed fund can have substantial gains if managers choose less-diversified portfolios.

The rest of the paper is structured as follows. In section 2 we briefly discuss related literature. In section 3 we provide motivation and our methodology. In section 4 we summarize the dataset. In section 5 we describe the results and their implications. Section 6 concludes.

Related literature

There are several plausible reasons why examining total portfolio performance may be misleading concerning stock-picking skills. First, manager compensation is often tied to the size of the fund’s holdings. As a consequence, managers may have incentives to continue investing fund capital after their supply of alpha-generating ideas has run out. This tension has been the subject of recent analysis, highlighted by the work of Berk and Green (2004). Second, the very nature of fund evaluation may cause managers to hold some or even many stocks on which they have neutral views concerning future performance. In particular, since managers may be penalized for exposing investors to idiosyncratic risk, diversification may cause managers to hold some stocks not because they increase the mean return on the portfolio but simply because these stocks reduce overall portfolio volatility. Third, open end mutual funds provide a liquidity service to investors. Edelen (1999) provides strong evidence that liquidity management is a major concern for fund managers and that performance evaluation methods should take it into account. Alexander et al. (2007) show explicitly that fund managers trade-off liquidity against valuation motives, when making investment decisions. Finally, even if managers were to only hold stocks that they expect to outperform, it is likely that they believe that some of these bets are better than others.

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