Active Managers Shifting To Smaller, More Focused Portfolios To Achieve Outperformance

Active Managers

Here’s a great article at Bloomberg that discusses the changing landscape for active investors. The article reports that more and more active managers are moving to smaller, more focused portfolios. The logic behind the shift is that a smaller, more focused portfolio is more likely to achieve outperformance as it deviates away from the so-called ‘benchmark hugging’ style portfolios which are filled with a much large number of holdings.

[REITs]

See 2017 Hedge Fund Letters.

Here is an excerpt from that article:

In a world where almost nothing seems capable of halting the spread of passive investing, active managers are looking for a lifeline.

Their solution: smaller, more focused portfolios.

Institutional investors are raising their allocations to so-called focused strategies — defined as portfolios holding 50 names or fewer — and distributors are increasingly recommending them to clients, according to a study released by Greenwich Associates in conjunction with Fred Alger Management Inc. Plus, for both large- and small-cap funds, they overwhelmingly believe this is the optimal way to deliver performance.

“It’s indisputable that passive has gained momentum in the marketplace,” said Jim Tambone, Alger’s chief distribution officer. “Passive has essentially created a floor for returns. In other words, you must beat passive or you don’t survive.”

Total assets in index-based passive strategies in mutual funds and exchange-traded funds have swelled to $6.8 trillion from $2.7 trillion five years ago, according to Morningstar. Roughly a third of U.S. assets are now invested this way, but the percentage is rising fast as cash increasingly flows out of active funds and into passive vehicles. That growth has become a looming shadow over active managers, who are pressured to beat benchmarks and cut costs.

Take a look at the numbers in the Greenwich-Alger study, which was conducted from September to November of last year. Of the 91 “key decision makers” questioned, more than half of the institutional investors said they’d increased their allocations to focused strategies in the previous 18 months, and the same amount expected their interest to grow over the next two years. For intermediaries, about a third upped their contributions to smaller strategies, and more than 60 percent expect their enthusiasm to rise.

Active Managers

The logic behind the shift is that these tightly focused portfolios hold the stocks the investment managers most believe in, which will induce outperformance. In addition, these smaller groups should deviate further away from indexes than so-called benchmark huggers, which have large holdings that all but match the index they’re chasing. If the strategies are more differentiated — what asset managers call “active share” — they also should have a better chance of outperforming passive indexing. Or so the thinking goes.

“Your probability of outperforming the market is going to be much greater with 10 stocks than with 1,000, because once you’re at 1,000 you’re essentially the market,” Tambone said. “I want high conviction, and I need to have high active share, and if I have high conviction and high active share, there’s a better probability I’ll have a tracking error that I’m looking for. And when I combine those three data points, I improve the probability that I’ll have high alpha.”

You can read the entire article at Bloomberg here.

For more articles like this, check out our recent articles here.

Article by Johnny Hopkins, The Acquirer’s Multiple

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The Acquirer's Multiple
The Acquirer’s Multiple® is the valuation ratio used to find attractive takeover candidates. It examines several financial statement items that other multiples like the price-to-earnings ratio do not, including debt, preferred stock, and minority interests; and interest, tax, depreciation, amortization. The Acquirer’s Multiple® is calculated as follows: Enterprise Value / Operating Earnings* It is based on the investment strategy described in the book Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations, written by Tobias Carlisle, founder of acquirersmultiple.com. The Acquirer’s Multiple® differs from The Magic Formula® Earnings Yield because The Acquirer’s Multiple® uses operating earnings in place of EBIT. Operating earnings is constructed from the top of the income statement down, where EBIT is constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–earnings that a company does not expect to recur in future years–ensures that these earnings are related only to operations. Similarly, The Acquirer’s Multiple® differs from the ordinary enterprise multiple because it uses operating earnings in place of EBITDA, which is also constructed from the bottom up. Tobias Carlisle is also the Chief Investment Officer of Carbon Beach Asset Management LLC. He's best known as the author of the well regarded Deep Value website Greenbackd, the book Deep Value: Why Activists Investors and Other Contrarians Battle for Control of Losing Corporations (2014, Wiley Finance), and Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors (2012, Wiley Finance). He has extensive experience in investment management, business valuation, public company corporate governance, and corporate law. Articles written for Seeking Alpha are provided by the team of analysts at acquirersmultiple.com, home of The Acquirer's Multiple Deep Value Stock Screener. All metrics use trailing twelve month or most recent quarter data. * The screener uses the CRSP/Compustat merged database “OIADP” line item defined as “Operating Income After Depreciation.”

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