Conviction in Equity Investing

Abstract

Active management plays a critical, positive role in the efficiency of capital markets. In the first study of its kind to use data on institutionally-focused products, we find that, while a large percentage of active equity managers earn enough alpha on average to cover their costs, less than 2% have demonstrated evidence of skill net of fees. The demonstrated skill level in active equity has steadily declined since the 1990s. Recent research suggests that the equivalent skill figure for hedge funds is over 30%. Only the best of the best active strategies — not just standard “buy list” managers — representing the highest conviction of the investor are likely to be successful in adding value. Statistical analysis of track records is a valuable tool for assessing our odds of success given a large dataset; it is not a replacement for expert analysis of skill. Strategies that are highest-conviction on the part of the manager — higher active risk, less benchmark-sensitive portfolios — offer demonstrably better odds of success. Most institutional investors take a disproportionately small amount of risk with active management compared with the resources spent on the effort and reasonable expectations for value added. Given these facts, we believe that Investors should consider: an all-passive Efficiency approach to public equity that is likely to outperform the average investor, or: a high-conviction, mostly active Opportunity approach that maximizes the probability of success with active management. We believe the Efficiency model is optimal for most investors. At a minimum, investors should avoid “closet indexing” and employ a combination of low cost passive management and high conviction active strategies. We call on investment managers, consultants and asset owners to step up their game to fix the dysfunctional traditional equity active management model.

Keywords: equity, active, passive, indexing, skill, concentrated portfolios, active risk, tracking error, alpha, closet indexing, hedge funds, market efficiency, significance, false discoveries

JEL Classification: G00, G10, G14, G19, G20, G23, G29