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How many attractive stock ideas does Naomi, an institutional active equity fund manager, have at any one time?
“Oh, I think between 10 and 20,” she told me.
So, why did her fund hold so many more times that number of stocks?
“To round out the portfolio,” she said.
I have asked these same questions of many active equity managers and received similar responses each time. The implication, of course, is that these managers are drowning the superior performance potential of their best ideas in a sea of bad ones.
Why would they hobble their returns in this way? After all, no expert chef would serve up their signature dish with generic supermarket bread. Why do skilled stock pickers make such errors when constructing portfolios, and what can we do about it?
Are professional managers skilled stock pickers?
The consensus is “no,” they are not. On average, active equity funds fail to meet their benchmarks, which suggests that investors should avoid them in favor of low-cost index funds.
But what if managers like Naomi stuck to their 10 to 20 preferred stocks? Would their portfolios do better? Studies confirm that they would. In the most compelling of these, “Best Ideas,” Miguel Anton, Randolph B. Cohen, and Christopher Polk find that the performance of the top 10 stocks held by active equity mutual funds, as measured by portfolio weights relative to index weights, significantly exceeded their benchmarks. As the relative weights decline, however, performance faded and at some point, probably around the 20th stock, fell below the benchmark.
Professional managers are superior stock pickers – if they stick with their 10 to 20 best ideas. But most mutual fund portfolios hold many more bad ideas than best-idea stocks.
Collective stock-picking skill
Applying a variation of the “best ideas” relative-weight methodology, my firm, AthenaInvest, rates stocks by the fraction held by the best active equity funds. We define the best funds as those that pursue a narrowly defined strategy and take high-conviction positions; we update our objective fund and stock ratings based on monthly data. The best and worst idea stocks are, respectively, those most and least held by the best U.S. active equity funds. We derive each stock’s rating from the collective stock-picking skill of active equity funds with distinct strategies.
The following chart presents the annual net returns of best and bad idea stocks from 2013 to 2022 as distilled from more than 400,000 stock-month observations. The two best ideas category stocks eclipsed their benchmarks by 200 and 59 basis points (bps), respectively, as measured by the average stock return net of the equally weighted S&P 500. The bad idea stocks, by contrast, underperformed. (These results would have been even more dramatic had we excluded large-cap stocks, since stock-picking skill decreases as market cap increases (the smallest market-cap quintile best idea returns far outpaced those of the large-cap top quintile best ideas).
Performance declined as the best funds held less and less of a stock. Those held by fewer than five best idea funds – the rightmost category – returned -646 bps.
The designations reflect AthenaInvest’s roughly normal distribution rating system. The two best idea categories comprise 24% of the market value held by funds, while the bad ideas account for 76% and so outnumber good ones by more than 3 to 1.
The market value-weighted average annual return of all stocks held by funds was -53 bps before fees. Yet had the funds invested only in best ideas, they would have exceeded their benchmark. By diversifying beyond their best ideas, stock pickers sacrificed performance to build bad-idea funds and became, in effect, closet indexers.
Read the full article here by C. Thomas Howard, Advisor Perspectives
