The Importance of Investment Strategy

Abstract

Superior stock picking is common among active equity fund managers. The reason stock picking skill is not detected by many performance studies is over-diversification, which overwhelms the superior performance of top holdings. Managers who do not over-diversify outperform by an astonishing 6% to 12% annually. The style grid is a significant contributor to this over-diversification problem. In addition, the grid does not help investors identify successful active managers, since stock characteristics, such as market-cap and PE, are unrelated to superior performance. Using self-declared investment strategy for organizing the active equity universe frees managers to pursue a narrowly defined strategy and helps in identifying successful managers within each strategy. I provide statistically significant evidence that funds are more alike within strategies than across, that strategy clustering funds is superior to either random or style grid clustering (which itself is inferior to random clustering), and that each of the 10 strategies generates returns in a unique way. Furthermore, stocks can be strategy categorized based on the collective judgment of the strategy managers who hold them. The resulting strategy stock pools move about the equity universe over time, independent of stock characteristics. Those managers who hold the largest number of own strategy stocks outperform those who hold the least by a statistically and economically significant 3.21% annually.

Keywords: stock picking skill, investment strategy, actionable return factors, strategy stock pools, investment strategy consistency, and excess returns

JEL Classification: G11, C82