Investment Strategy: When Does Stock Picking Work?
High return dispersion and volatility are a stock picker’s nirvana.
Some markets challenge active equity managers more than others. Many of the best funds, described in the previous article in this series, have underperformed in recent years, even though they consistently pursue their strategy while taking high-conviction positions. This begs the question of whether returns to stock-picking vary over time.
This is the fourth article in a series on the power of investment strategy. 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. The third article explained how to identify the best funds within each strategy.
Active Equity Opportunity
Indeed, there is considerable anecdotal evidence that stock picking is effective in certain market environments while not in others. Academic research confirms this, with studies by Gorman, Sapra and Weigand, Petajisto, and von Reibnitz providing a basis for measuring how favorable or unfavorable the current market environment is for stock picking.
They paint a picture in which the returns-to-skill rises in tandem with increased stock return cross-sectional dispersion and skewness, along with greater market volatility. That is, high levels of cross-sectional and longitudinal volatility represent a stock picker’s nirvana.
Based on these articles, I created active equity opportunity (AEO), a measure of how active the emotional crowds are driving individual stock-return dispersion. The more active the crowds, the greater the returns-to-skill are and vice versa.
Active equity managers who build a strategy for harnessing a specific set of return factors prefer a higher level of AEO, since it is more likely their high-conviction picks will outperform. On the other hand, a low AEO foretells a period in which it will be difficult for even the most talented to beat their benchmark.
Active Equity Opportunity (AEO)
A measure of how active the emotional crowds are driving individual stock-return dispersion. The more active the crowds, the greater the returns-to-skill are and vice versa.
AEO is estimated as a scaled, weighted average of these four components, listed from most to least important:
• Individual stock cross-sectional standard deviation
• Individual stock cross-sectional skewness
• CBOE Volatility Index (VIX)
• Expected small stock premium
The resulting monthly values for AEO from December 1998 through July 2018 are presented in Figure 1. The average AEO over this time period is 40, which means values greater than 40 signal a better environment for stock picking while lower values signal a worse environment. During this 20-year time sample, 1998 through 2006 and 2008 through 2010 favored stock picking.
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.
FIGURE 1: ACTIVE EQUITY OPPORTUNITY. (DECEMBER 1997 – JULY 2018)
Sources: Morningstar and AthenaInvest.
Of particular interest is that since 2010, AEO has mostly been below average, declining to an all-time low of 18 in mid-2017. It since rebounded to 41 in February 2018, falling to 30 in July 2018.
The red shaded areas represent recessions according to the National Bureau of Economic Research, the official arbiter of business-cycle turning points. While there seems to be a relationship between recessions and higher levels of AEO, von Reibnitz, based on a longer 1972 through 2013 fund sample, concludes that “the positive relation between fund activeness and performance is driven by return dispersion, as opposed to business cycle fluctuations.” That is, the impact of AEO on stock picking is largely independent of where we are in the business cycle.
Stock-Picking Skill Is Robust, but Returns Are Not
Figure 2 presents the impact of AEO on stock alpha of the best idea stocks of the best funds (i.e. truly active as described in the previous article) versus the worst ideas of the worst funds (i.e. closet indexers). The best (about 10% of all stocks held by active equity funds) are those most held by strategy consistent, high conviction funds, while the worst are those most held by strategy inconsistent, low conviction funds. Best and worst idea stocks are identified by aggregating fund relative holdings..
FIGURE 2: STOCK PICKING BENEFIT VS ACTIVE EQUITY OPPORTUNITY (AEO)
Alpha is stock return net of the Fama & French monthly market returns available on Ken French’s website. Includes all stocks held by at least five active equity mutual funds in each month from January 1998 through May 2017. Sample comprises about half of the stocks traded on US exchanges each month and tens of millions of stock-fund-month observations. The reported results are from a regression of subsequent month stock alpha averages on month beginning AEO. The 20 to 60 range captures 85% of the observed AEO monthly values during this time-period. Data sources: Morningstar and AthenaInvest
Figure 2: Stock-picking benefits vs. AEO Alpha is stock return net of the Fama & French monthly market returns available on Ken French’s website. Includes all stocks held by at least five active equity mutual funds in each month from January 1998 through May 2017. Sample comprises about half of the stocks traded on US exchanges each month and tens of millions of stock-fund-month observations. The reported results are from a regression of subsequent month stock alpha averages on month beginning AEO. The 20 to 60 range captures 85% of the observed AEO monthly values during this time-period. Data sources: Morningstar and AthenaInvest.
Skill benefits remain strong even at low levels of AEO, with differences averaging over 10%, confirming that funds are able to distinguish good from bad investment ideas. Skill benefits increase as AEO increases, reaching 15% at AEO of 60. So, stock-picking skill exists no matter the current state of the economy and the market.
However, as AEO drops, more and more stocks held by funds generate negative alpha. At AEO of 20, only the best ideas (top 10%) generate positive alpha while the other 90% sport a negative alpha. Thus, even best funds, those that consistently pursue their strategy and focus most on high-conviction stocks, can underperform when AEO is low, in spite of their investment team’s stock picking prowess. This comports with the anecdotal evidence that stock picking is effective in certain markets while not in others.
In a period of low AEO, it may be beneficial to allocate less to stock picking and more to market exposure. Later in the series, we’ll show that aggregating fund-relative holdings by strategy, and short-term ranks by investor preference prove useful for estimating expected individual stock and market returns.
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.
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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.
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