The challenge of accurately selecting actively managed funds just got easier due to new research recently released from Turing Technology. The research, based on evaluating years’ worth of daily holdings from more than $2.25 trillion in actively managed fund assets, had some paradigm-busting insights into how and where active managers add value – and where they don’t.
First insight, active managers typically add significant value from stock picking, but this skill is limited to their ‘Best Ideas’. We can stop the debate – most managers have skill. But it is only found in their Best Idea – their biggest relative bets versus the benchmark (referred to by Turing as High Conviction Overweight positions, or “HCOs”).
Second, the average fund only allocated 55% of its investment dollars to their Best Ideas. This is the problem, because for the average fund, the single engine of stock selection alpha is operating at only half its potential impact. Before fees. In practice, this under-allocation to HCOs sabotages the average active fund’s ability to outperform, and it has a larger negative impact on performance than fees.
This research, therefore, highlights two new metrics that provide unprecedented insight into evaluating actively managed funds: 1) the performance of the fund’s HCOs, and 2) the fund’s HCO allocation.
According to Alexey Panchekha, President of Turing and the author of the study, “This research changed how we think about screening funds. Just like Billy Beane and Moneyball taught us On-Base-Percentage is a better metric to evaluate players than Batting Average, this research shows that HCO performance is more informative than overall Fund performance.”
For the fund to outperform, the manager’s Best Ideas absolutely must outperform. Evaluating the performance of just the HCOs provides an uncluttered look directly into the manager’s stock picking skills. And if the manager’s Best Ideas deliver value, then common sense says that the bigger the allocation to those stocks the better.
The numbers from the study prove this theory out. Funds with the best performing HCOs and with at least a 60% HCO allocation delivered an average annual excess return of 455 basis points (4.55%) over rolling one-year periods. Funds with top performing HCOs but with an HCO allocation less than 40%, only delivered 183 basis points (1.83%) in annual excess returns. Both groups succeeded (because their HCOs outperformed), but increasing the HCO allocation from under 40% to over 60% increased investor returns by 2 ½ times.
Mr. Panchekha added, “Investors should call their fund company and ask for this data. You should know how well the manager’s Best Ideas fared, and how big a part of the fund they are. Even if they do not yet have this information at hand, it is fair to ask. And the HCO allocation is particularly easy to measure.”
To learn more about Turing Technology or to download a copy of the study, please visit www.turingta.com. An edited version of the study was published by the CFA Institute, and can be found at https://blogs.cfainstitute.org/investor/2019/10/03/the-active-manager-paradox-high-conviction-overweight-positions/.
