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By M. Isi Eromosele
Concentrated portfolios are considered an effective means
for capturing market dislocations. Traditionally, concentrated fund managers
are often constrained by either a mandated holdings requirement or by sector restrictions.
These top-down constraints can limit the ability of portfolio managers to
select their favorite securities and to achieve excess returns.
A focused strategy, while similar to many concentrated strategies
in that it is driven by a bottom-up analytical freedom permits portfolio
managers to focus solely on their best investment ideas.
Defining Risk In Equity Portfolio Management
The concept of risk, or at the least its perception, drives
both investment management styles and the relevant asset allocations. There is
a differentiation between market risk (systematic/undiversifiable risk) and
active risk (idiosyncratic/diversifiable risk).
Active risk (or a portfolio manager’s ability to exercise it)
is what generates alpha, the portfolio’s returns in excess of its related
benchmark and represents the conventional way of explaining excess returns on the part of actively managed
portfolios.
It is generally accepted that while the equity markets may
trend towards price equilibrium in the long term, short-to-medium-term investment
opportunities remain. This tendency can be exploited by portfolio managers to
generate returns that will outpace the market.
Active and passive management are commonly distinguished by
their tracking error; passively managed funds’ usually are very low, if not
inconsequential while those of active funds tend to fluctuate, depending on the strategy
employed.
Essentially, active share tracks the sum of the total active
bets (absolute values divided by 2) within a given portfolio. A portfolio with
a high active share and a management strategy that focuses on ex antestock
selection, combined with higher tracking error, typically outperforms peers given
the outsized active bets at an individual security level.
The active share characteristic, rather than the tracking
error is the significant, relevant factor in detecting top-performing funds. Therefore
active, concentrated portfolios create greater prospects for alpha production, compared
to traditional long-only concentrated portfolios.
Muted Risk
When determining the relevance of an active, focused portfolio
strategy, it is pertinent to examine the effect on diversifiable risk and the
potential for alpha. However, this fails to track the portion of the portfolio
returns that correlates to beta.
In an attempt to further differentiate true alpha, the terms
should be defined in three components: active return, active risk and costs. Active
risk seeks to separate both beta and other “systemic factors” that contribute
to total risk.
Alpha is too broad and ill-defined a determinant when separating
the superior and inferior performance of fund managers. There is a difference
between passive-active and true active through a decomposition of a portfolio’s
returns.
What distinguishes a truly actively managed fund is the positive
correlation of its holdings weights and their respective returns. A portfolio
benchmarked against the S&P500 with positive risk premia can achieve alpha
solely from the equity risk premium
imbedded in each of its holdings.
Using alpha solely to determine the efficacy of a portfolio manager
is flawed, as it does not evaluate how much a respective fund benefits from the
individual market risk associated with each of its holdings.
Many managers attempt to mitigate tracking error in their
portfolios and essentially pursue what is conventionally referred to as a
passive-active strategy.
This means a manager can avoid a large tracking error in his/her
portfolio by pursuing sector allocations that mirror the distributions in the
related benchmark through a higher degree of diversification. This can be attained
by increasing the number of holdings in a given portfolio (i.e., a portfolio
with 30 stocks is more likely to have a greater tracking error than one with 100).
Active share is an effective predictor of funds that are
truly dynamic and exhibit superior performance. As previously indicated, portfolios
with a large active share quotient have consistently demonstrated strong returns.
Tracking error alone is a flawed methodology for tracking
active managers because the metric is not “one-dimensional.” Therefore, using a
singular classification will yield deviant results.
The Focused Investor
Modern portfolio management requires that to lower the
volatility of returns, investors should diversify their holdings. This
prevailing perspective measures the relationship between the mean and variance
of portfolio returns and expands on the notion that markets are efficient.
However, while most developed markets may tend towards long-term
price equilibrium, inefficiencies remain during the interim period that may be
managed by the prudent investor.
As a result, diversified portfolios will not necessarily
offer the excess returns required to justify their costs. Typically, these types of strategies follow
a top-down analytical structure that is not able to nimbly navigate market
dislocations, particularly in mature markets.
Concentrated portfolio construction represents an answer to
the shortcomings of diversified portfolio investing in mature markets. Bottom-up
analysis, which is less fixated on the sector weights of benchmarks, offers
opportunities to exploit market irrationality on a security-by-security basis.
A focused portfolio strategy, like many concentrated ones, pursues
a bottom-up analysis that drives a small number of holdings. In addition, the
focused portfolio strategy is not constrained by a required number of positions:
fund managers are given the flexibility to determine the holdings depending on analyst recommendations.
This flexibility and ability to adapt is what separates it
from both traditional diversified and concentrated portfolio construction. This
investment approach enables investors to advantageously seize on market inefficiencies
as they present themselves when investing in developed markets.
Active Or Focused Strategy
Investors seeking to create a focused fund strategy should, therefore,
shift their attention from creating a portfolio of stocks and concentrate on
bottom-up analysis to generate investment ideas defined by the following:
- Portfolio
construction that is solely based on the stock-picking ability of the fund
manager
- The
focused manager has intimate knowledge of all positions at any given time
and the investment flexibility to own any number of stocks within their guidelines
- The focused fund strategy is driven solely by top investment ideas (whereas traditional concentrated portfolio managers are often required to own a set number of stocks)
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2012 Oseme Group
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