We believe that high-conviction investing is key to generating excess long-term returns, and this belief guides our research efforts and investing decisions. There is academic research to support this, showing that among actively managed funds, those with high conviction managers tend to outperform. In this blog post I’ll explain why the Trimark Global Equities team invests with conviction, highlighting two extensive studies of portfolio managers and their returns.
The first study, by Barras, Scaillet, and Wermers (BSW) in Journal of Portfolio Management (2010)1, looks at the performance of 2,000 U.S. equity mutual funds from 1975 through 2006 to evaluate whether the managers’ excess returns covered fees. Managers who outperformed, on average, after fees, were classified as “skilled”, while those who delivered zero or negative alpha after fees were classified as “unskilled”.
The second study, conducted by institutional consulting firm Hewitt Ennisknupp (HEK)1, analyzed nearly 3,500 institutional managed accounts, commingled funds and mutual funds that invested in U.S. equity and non-U.S. equity strategies from 2000 through 2011. The study also divided managers into categories based on their level of alpha2 after fees during the period studied.
The search for alpha
The results of the two studies were striking in that the majority of investment managers fell into the “no evidence of net alpha” camp. These managers delivered enough alpha to earn back their fees and costs, but did not provide a meaningful excess return to investors.
The number of skilled managers who generated positive alpha net of fees and administrative costs steadily declined over the periods covered by the studies. The BSW study concluded that only 0.6% of managers showed evidence of skill, while the HEK study found evidence of skill in 1.6% of the investment products studied.
These proportions represent a considerable decline from the early 1990s, when, according to the BSW study, about 20% of managers delivered alpha in excess of their fees. It should be noted that the slight discrepancy between the two studies is likely attributed to the broader product universe studied by Hewitt Ennisknupp.
Is high conviction linked to long-term success?
The results of these studies suggest that the highest-conviction managers are more likely to outperform consistently over the long term. The definition of conviction, according to the researchers, is the willingness to express beliefs through bold courses of action in pursuit of long-term goals. While it is difficult to measure a managers’ conviction, the researchers identified certain portfolio attributes that have consistently been linked to high conviction and long-term success:
- Concentrated portfolios
- High active share3
- A willingness to step away from the benchmark
The Trimark Global Equities team has long believed that managing concentrated portfolios based on well-researched ideas is crucial to high-conviction investing. Not limiting ourselves to a pre-defined benchmark is equally important in achieving differentiated performance. There are several reasons why we prefer a benchmark-agnostic approach:
- Many benchmarks include large weights in industries and sectors that tend to fall short of our quality criteria, while off-benchmark securities that possess the characteristics we look for may be excluded from the benchmark for institutional reasons – such as a company recently going public. We prefer to develop our conviction in a business by focusing on business quality, and not on representation in an index.
- Managers that try to avoid straying too far from benchmark performance expose themselves to the risk of buying securities that are overvalued. For example, in the late 1990s, many investors increased their exposure to the technology sector as the relative weight of technology stocks in the benchmark increased dramatically. This behaviour directly contributes to speculative bubbles in certain asset classes and increases the risk of permanent capital loss. Our conviction in a company is solely based on a thorough analysis of business quality and competitive advantage. We do not fear deviating from our peers.
- Many capitalization-weighted benchmarks are backward-looking and may exclude or underweight high-quality small-cap companies that are benefitting from robust growth trends in their respective industries. By the time these companies become large enough to be included in the benchmark at a substantial weight, the strong return potential stemming from their growth may be tempered.
- Benchmarks in many global markets tend to have a large proportion of companies with high levels of government ownership. We believe such companies are less aligned with shareholder interests over the long term, and prefer not to limit our investment universe in this way. Thoroughly researching in order to find an honest and capable management team that allocates capital in the best interest of shareholders helps build our conviction in an investment idea.
Because we devote 100% of our time to uncovering and researching businesses that meet our investment criteria, we construct concentrated portfolios of our best ideas. Each holding is selected on the merits of business quality, competitive advantage sustainability and valuation.
We do not spend any time researching low-quality businesses simply because they are part of a benchmark index. Thus, being benchmark agnostic is key to our high-conviction investing approach.
For more information on the Trimark Global Equities team, visit www.invesco.ca/trimark.
To see how this high-conviction approach impacts fund performance, check out Invesco’s star performers.