What makes a good active equity manager?
Back to basics The world of equity funds is becoming increasingly diverse and offers a bewildering array of strategies. How should one best navigate this and find the most suitable fund? By not forgetting the basics! A solid starting point is ascertained by defining a risk budget. Once determined you will find that you create a narrower and more manageable universe which still offers many interesting approaches to finding outperformance in equity markets. You can thus evaluate potential returns relative to the risk budget by using measures such as the Sharpe ratio. Some active managers add value by implementing high conviction ideas. This means finding someone who thoroughly knows their stocks, the stories behind them and the ‘right’ price for each stock. A relatively concentrated portfolio of around 40-60 ideas can allow for this degree of focus and allows utilisation of the best research ideas. From a risk perspective, the investor can perhaps seek some comfort from the idea that a stock story must be very strong before it makes it into or indeed is sold out of a relatively small portfolio.
Generating ideas What the investor is ultimately seeking is return within a risk-managed framework. The popularity of the concept of absolute return has taught us that orienting a portfolio around a benchmark is not the only way of providing a risk managed portfolio. While a more concentrated portfolio which does not hold everything in the index may appear a lot more high risk, by freeing managers to pick stocks both inside and outside an index you actually allow them to concentrate the risk in areas they feel will be compensated and avoid sources of risk that are ultimately unlikely to be sources of return. The result – avoidance of mediocrity and a concentration on strong return potential ideas. A less constrained approach may encourage passionate commitment to original, robust and well-researched investment ideas. We should thus allow managers to search for ideas across all market capitalisations. Often portfolios will have a large cap bias because they make close reference to their benchmark but, if a smaller company has better growth prospects and a stronger risk reward profile then it makes sense to give more weight to this small cap. In the same way, stock ideas can come from both the developed and developing markets. For example, a European equity manager may find stronger fundamentals displayed in stocks from emerging Europe that aren’t listed on the MSCI Europe thus again it makes sense to allow their inclusion. But what about diversification? You could take this concept further and invest in a best ideas fund. These focused funds which often consist of as little as 20 stocks, may seem not diversified enough. However, recent research into modern portfolio theory shows that most of the diversification you can achieve by adding more stocks happens in the first 20 stocks thus a portfolio of 25 stocks offers only fractionally more diversification benefits than a portfolio of 20 stocks. Risk, therefore, is not proportionately reduced with each additional stock in a portfolio, and investors are not taking on too much undue risk by investing in these concentrated funds. High return potential A concentrated fund can certainly have a place within a diversified total portfolio. Due to its greater concentration, it may experience higher levels of volatility than a larger fund. But with skilful stock selection and an in-depth knowledge of holdings, a concentrated fund typically offers higher return potential over a longer period of time to compensate for the additional volatility. After all, the key concept of active management is for managers to pick stocks that are undervalued and will eventually beat the market. By giving managers all the tools available to aid that search, your portfolio potentially benefits more from ‘alpha’ aka manager skill rather than ‘beta’ aka rising markets. Therefore, when choosing this kind of manager you should seek one with an entrepreneurial approach and a strong, consistent investment philosophy. In this way, you will be gaining the best value from your active management fees.
