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Investment Strategy: Identify the Best Active Equity Funds

Funds that consistently pursue a narrowly defined investment strategy while taking high-conviction positions outperform.

 Strategy 3 Intro Image

Fund manager behavior is predictive while past performance is not. The second part of that statement, we hear often. The importance of fund manager behavior is less known and discussed as part of this article series.

The first article introduced investment strategy as an alternative to the style grid for forming active equity mutual fund peer groups. The second article discussed the advantage of diversifying equity portfolios based on fund strategy and proposed a six-strategy core equity portfolio. This article explains how to identify the best funds within each strategy.

Strategy Consistency

An important fund manager behavior is the consistent pursuit of a narrowly defined strategy. The challenge is how to measure consistency. A common approach is to demand consistent returns over time. But we know that the best funds outperform at times and underperform at others. While this is emotionally difficult for investors, it is an unavoidable fact when investing in successful active funds as strategies don’t perform well in all types of markets.

Another common approach is to demand that funds closely track their style box benchmarks. Such funds, however, while acting like their benchmarks, underperform as demonstrated in this study. Benchmarks have little to do with a manager’s strategy so asking them to minimize tracking error is tantamount to asking them to deviate from their strategy. This is because they are being required to purchase stocks for the sake of staying in their assigned style box, rather than investing in their preferred stocks.

An alternative is to examine the type of stocks in which a manager invests. For example, is a value fund invested in value stocks or is it chasing an unrelated trend such as favoring growth stocks?

Using a more definitive process, we evaluate consistency of a manager by comparing their holdings to other managers pursuing the same strategy for a pool of stocks upon which to focus. For a manager following a “Competitive Position” strategy, for example, the pool is comprised of stocks most held by other “Competitive Position” funds.

Consistency Evaluation

We evaluate consistency of a manager by comparing their holdings to other managers pursuing the same strategy for a pool of stocks upon which to focus.

It makes intuitive sense to use a screen driven by those who are looking for similar stock characteristics. In addition, strategy pools are in constant motion, as managers make buy and sell decisions based on ever-changing economic and market conditions. A stock stays in a particular strategy pool for 14 months on average. (See this study for details on how strategy stock pools are created.)

Focusing on similar strategy stocks is not only intuitively appealing but it leads to better performance, as shown in this study.

Figure 1 demonstrates that the active equity funds holding the most similar strategy stocks (Quintile 5 in Figure 1) outperform those holding the least by 212 basis points. This confirms the advantage of focusing on stocks most held by others following the same strategy. Collective intelligence provides valuable information.

Strategy3image1

Sources: Morningstar and AthenaInvest.

These strategy-consistency results are in stark contrast to what has been uncovered regarding style-box consistency. This study demonstrates that equity funds experiencing the largest style drift outperform those with the least by about 300 basis points. Asking a fund manager to stay style-box consistent hurts performance because it forces them to invest in stocks outside their own strategy simply to track the style benchmark. Style consistency begets strategy inconsistency and, in turn, poor performance. 

High-Conviction Stocks

There is an additional performance advantage if a fund invests exclusively in high-conviction stocks.

A fund applies its investment strategy to hundreds of its own strategy stocks to come up with a manageable set of high-conviction stocks. Even though two funds might pursue the same strategy, their implementation is unique. Thus, funds pursuing the same strategy can hold quite different high-conviction portfolios.

The benefit of holding only high-conviction stocks is demonstrated in Figure 2. Increasing the amount invested in the top 20 high-conviction stocks (captured by the highest 20 relative weights in the portfolio) improves fund alpha, represented by the two green bars in Figure 2. Increased investment in the non-top-20 stocks hurts performance, as represented the single red bar.

 Strategy3image2

Sources: National Bureau of Economic Research, Morningstar, and AthenaInvest.

Figure 2 reveals that funds display stock-picking skill as evidenced by investing more money in their best-idea stocks, which subsequently outperform. It also reveals that the typical mutual fund holding 75 stocks (the median number of holdings) is badly overdiversified, investing in three times more alpha-destroying stocks than in alpha-building stocks.

This provides further support for the argument that active equity funds should not grow too large (no larger than $1 billion in assets under management) nor be asked to minimize tracking error, both which encourage investing in non-high-conviction stocks.

Consistency and Conviction Are Key

Forming active equity funds into strategy peer groups allows for superior portfolio diversification along with the ability to select funds with the best chance for outperformance.

Funds that consistently pursue a narrowly defined strategy while taking high-conviction positions perform best. Past performance is not part of this fund selection process because it is not a reliable predictor. Fund behavior, in terms of consistency and conviction, however, is predictive.

In the next article in this series, I will describe market environments that favor active equity fund outperformance.

 

IMPORTANT INFORMATION AND DISCLOSURES

This document is informational in nature only. Nothing herein is intended to imply that an investment in this portfolio may be considered "safe" or "risk free." This investment portfolio may not be suitable for all types of investors. This information is not intended to constitute legal, tax, accounting or investment advice. Prospective clients should consult their own advisors about such matters. No regulatory authority has passed upon or endorsed this summary or the merits of an investment using our strategy.

PORTFOLIO PERFORMANCE Monthly performance results include all discretionary accounts within the Athena Global Tactical ETFs portfolio including accounts that are no longer active as of the time of the publication of this document. Accounts are included in the composite performance after the day the initial portfolio position trades settle to the present or to the closing of the account. Performance results are asset-weighted composite returns calculated using a daily wealth relative method. Composites are valued daily, and cash flows are accounted for on a daily basis. Monthly returns are calculated based on the daily wealth relative series and monthly geometric linking of performance results is used to calculate longer time period returns. Return figures are calculated using posting date accounting. All realized and unrealized capital gains and losses as well as all dividends and interest from investments and cash balances are included. The performance figures presented are net of brokerage commissions and all other expenses, including Athena’s management fee. The investment results shown are not representative of an individually managed account’s rate of return, and differences can occur due to factors such as timing of initial investment, client restrictions, cash movement, etc. Securities and portfolio weights used to implement the portfolio can differ based on account size, custodian, and client guidelines.

PORTFOLIO ALLOCATION GUIDELINES Information concerning portfolio allocations is representative of the target portfolio guidelines as of the publication date and does not necessarily reflect an actual client account. Actual client account composition may differ as a result of client-imposed investment restrictions, the timing of client investments, current market and economic conditions, and security availability. The investment manager may choose to substantially change asset class and individual security allocations at any time and without notice.

PRINCIPAL INVESTMENT RISKS An investment utilizing our investment methodology involves risks, including the risk of loss of a substantial portion (or all) of the amount invested. There is no assurance that the investment process outlined in this document will consistently lead to successful results. PAST PERFORMANCE DOES NOT GUARANTEE OR INDICATE FUTURE RESULTS. Risks of investing in the Athena Global Tactical ETFs portfolio include, but are not limited to: ETF, MF AND CEF RISK The cost of investing in the portfolio will be higher than the cost of investing directly in Electronically Traded Funds (ETFs), Mutual Funds (MFs) and Closed-End Funds (CEFs) and may be higher than other portfolios that invest directly in stocks and bonds. Each ETF, CEF and MF is subject to specific risks, depending on the nature of the fund. LEVERAGE RISK The portfolio may invest in ETFs which employ leverage, options, futures and other derivative instruments in order to amplify stock market movements or invert such movements. When the portfolio is invested in these ETFs, the portfolio will experience much greater volatility than does the underlying equity market. DERIVATIVES RISK Futures, options and swaps involve risks different from, or possibly greater than the risks associated with investing directly in securities including leverage risk, tracking risk and counterparty default risk in the case of over the counter derivatives. Option positions may expire worthless exposing the Fund to potentially significant losses. FOREIGN INVESTMENT RISK Foreign investing involves risks not typically associated with U.S. investments, including adverse fluctuations in foreign currency values, adverse political, social and economic developments, less liquidity, greater volatility, less developed or less efficient trading markets, political instability and differing auditing and legal standards. Investing in emerging markets imposes risks different from, or greater than, risks of investing in foreign developed countries.

BENCHMARK DISCLOSURE The benchmark for the Athena Global Tactical ETFs portfolio is comprised of 100% MSCI ACWI . This benchmark was selected to generally represent a similar opportunity set of investments compared with the portfolio. The portfolio does not seek to replicate the composition, performance, or volatility of the benchmark or its constituent indices and can be expected to have investments that differ substantially from the securities included in any index. Accordingly, no representation is made that the performance, volatility, or other characteristics of the portfolio will track the benchmark. It is not possible to invest directly in an index.

INDEX DEFINITIONS: MSCI ALL COUNTRY WORLD NET RETURN INDEX The Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets, including the United States. The MSCI ACWI consists of 45 country indices comprising 24 developed and 21 emerging market country indices.

CALCULATION DEFINITIONS: STANDARD DEVIATION Standard deviation measures the volatility of a return series around its mean. The higher the standard deviation, the more volatile the investment is. R-SQUARED R-squared is the percentage of a portfolio´s movements that are explained by movements in its benchmark. If a portfolio has an R-squared of 1.0, its price movements are explained entirely by its benchmark´s price movements. Conversely, a portfolio with an R-squared of 0.0 has no price movements which can be explained by its benchmark´s price movements. ALPHA Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility of a portfolio and compares its risk-adjusted performance to a benchmark. The excess return of the fund relative to the return of the benchmark index is a fund´s alpha. Alpha can be used as a measure of the value added or subtracted by the investment selection process. BETA Beta is a measure of the degree of change in value one can expect in a portfolio given a change in value in its benchmark. A portfolio with a beta greater than 1.0 is generally more volatile than its benchmark, while a portfolio with a beta of less than 1.0 is generally less volatile than its benchmark. SHARPE RATIO The Sharpe Ratio was developed by William Sharpe to measure risk-adjusted performance. The Sharpe ratio is calculated by subtracting the risk-free rate (3-Month US Treasury Bill Rate in this case) from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns. The greater a portfolio´s Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analyzed. UPSIDE / DOWNSIDE CAPTURE Upside capture is the average ratio of the return on the fund to the return on its benchmark for those periods in which the benchmark return was positive. Conversely, downside capture is the average ratio of the return on the fund to the return on its benchmark for those periods in which the benchmark return was negative. An upside capture ratio of greater than 100% means that the portfolio had greater gains than its benchmark during periods of positive benchmark returns while a ratio of less than 100% means that its participation in periods of positive benchmark returns was less than that of the benchmark. A downside capture ratio of greater than 100% means that the portfolio had greater losses than its benchmark during periods of negative benchmark returns while a ratio of less than 100% means that its participation in periods of negative benchmark returns was less than that of the benchmark. The combination of upside and downside capture ratios helps to determine how the portfolio´s volatility is split between periods of positive and negative benchmark returns. Upside and Downside Capture are not calculated for periods shorter than one year.

DATA DISCLOSURE All of the information included in this document is current as of the date indicated and is subject to change. Certain information has been obtained from various third-party sources believed to be reliable, but we cannot guarantee its accuracy or completeness. This information is not intended to be complete, and material aspects of the descriptions contained herein may change at any time. While the information prepared in this document is believed to be accurate, we make no express warranty as to the completeness nor can we accept responsibility for errors made in good faith.

INVESTMENT MANAGER Portfolio management is provided by AthenaInvest Advisors LLC, an SEC-registered investment advisor. Such registration does not imply that the Securities and Exchange Commission approves or endorses AthenaInvest, its investment strategies, or any of its marketing materials. The portfolio manager may invest all or a portion of this portfolio in pooled investment vehicles such as mutual funds or ETFs which are advised or sub-advised by the manager. In such circumstances, the portfolio manager will be paid a management fee for this portfolio and on the underlying pooled investment vehicle.

© 2018 Morningstar. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

It should not be assumed that recommendations of AthenaInvest made herein or in the future will be profitable or will equal the past performance records of any AthenaInvest investment strategy or product. There can be no assurance that future recommendations will achieve comparable results.

You are solely responsible for determining whether any investment, investment strategy, security or related transaction is appropriate for you based on your personal investment objectives and financial circumstances. You should consult with a qualified financial adviser, legal or tax professional regarding your specific situation. Investments involve risk and unless otherwise stated, are not guaranteed. Past performance is not indicative of future performance.   

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