(November 15, 2013) — Concentrated active investment strategies can create equity alpha, but it’s imperative to implement them in the right way to avoid excess risk, according to Hewitt EnnisKnupp.
Several consultants have extolled the virtues of high conviction or concentrated equity strategies, which sees managers invest in fewer stocks but employ greater levels of manager skill to create alpha.
Hewitt EnnisKnupp carried out research in 2012, and found the number of highly skilled active managers who did managed to produce solid alpha returns has fallen from 20% in the 1990s to around 2%-3% today.
If you’ve managed to seek out one of this 2% to 3%, the challenge then becomes how best to implement their strategy, since concentrated alpha equity often result in higher levels of risk.
Hewitt EnnisKnupp partner Matt Clink said there were three steps investors should follow: firstly, to spend time selecting the potential individual active managers; secondly, to combine those managers in a complementary way; and thirdly, to apply passive management if desired.
“Employing global equity mandates is the most practical approach for small to mid-sized institutional investors seeking to build a multi-manager portfolio with high active share, as it requires fewer managers than approaches with different mandates for regional and capitalization-focused subsets of the market,” said Clink.
“For larger investors, utilizing regionally or capitalization-focused strategies is also feasible. Each manager should have a high active share relative to its benchmark, i.e., an active share greater than 75% (or no more than a 25% overlap with the benchmark).”
Combining the managers doesn’t mean picking ones with the same investment strategies, Clink continued. But it was important to analyse the reduction in active share as each manager is added to the portfolio to avoid closet indexing.
The third and final step is to determine how much passive management to add to the portfolio. Passive management is used to lower cost, reduce tracking error, add a strategic regional or capitalization beta tilt, and to improve liquidity, Clink explained, although in some cases it might be abandoned completely if the investor wants to maximize their potential alpha and is comfortable with the fees.
For the full report, click here.
Hewitt EnnisKnupp wasn’t the only consultant to find value in high conviction portfolios. Data analysis carried out by Inalytics in April 2013 found diversified equity portfolios underperformed highly concentrated ones by almost 400 basis points.
Related Content: When is Diversification a Bad Idea? and Can You Have Too Many Bonds?