Much has been written about the “active versus passive” investment management debate. In my last blog post on October 10, 2019, I recounted the basics and the work shown by the SPIVA U.S. Scorecard. The Scorecard showed that for the one-year period ended Dec. 31, 2018, “for the ninth consecutive year, the majority (64.49%) of large-cap funds underperformed the S&P 500.”
New research recently posted on the CFA Institute blog website (at https://blogs.cfainstitute.org/investor/2019/10/03/the-active-manager-paradox-high-conviction-overweight-positions/) takes a shot at explaining the cause of this situation. In the article, the author studies a key parameter named “High Conviction Overweights” defined as the active manager’s “best” ideas that are represented by overweight positioning; somewhat analogous to the “active share” work done by others.
The conclusion: high conviction overweights, compared to underweights and neutral weights, were the only source of stock selection alpha. Paradoxically, the High Conviction Overweight positions were shown to be capped to an average overall portfolio weight of 55%; a weighting that is not high enough to propel the portfolios to outperformance. It is theorized that portfolio managers are averse to too large overweights due to the problem of high tracking error and the potential for significantly lagging a benchmark (i.e., business and career risk!). Regardless, the lack of a larger allocation to high conviction positions was a drag on outperformance.
The author used plenty of statistical tools to support their thesis and invites other academics to start researching this phenomenon. More work to be done on this research, for sure, but curious to see if this study causes active managers to change their portfolio management approach.