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Alpha Theory Blog - News and Insights

January 3, 2020

The Active Manager Paradox High-Conviction Overweight Positions

 

A 2019 article written by Alexey Panchekha, CFA called The Active Manager Paradox: High-Conviction Overweight Positions analyzes the performance of a funds' highest conviction positions as measured by position size over the benchmark. Each position was measured net of benchmark weight and the top 80% of positions above the benchmark were bucketed into High Conviction Overweights. The opposite group was the Underweights and everything else was the Neutrals. The Overweights outperformed the benchmark by 2.8% over the past five years.

 

The-Impact-of-High-Conviction-Overweights-Net-of-85-bps-Fees

114 managers with 85bps fees from 2014 to 2019. The performance data presented represents rolling one-year data (daily step), which was evaluated to capture the percent of rolling periods where each sub-portfolio was able to outperform the corresponding benchmark (Success Rate), and the average excess (or negative) relative return.

 

The author explains the conclusions below:

 

According to our research, the average manager sabotaged their returns by shrinking the High-Conviction Overweight stocks to an overall portfolio weight of 55%. The corresponding portfolio allocation to Underweights and Neutral Weights thus acts as a “Beta Anchor” that severely dilutes the alpha generated by High-Conviction Overweight positions.

 

While it is industry convention to blame these outcomes on higher fees, our research suggests that fees are only a secondary contributor. Diluting the sole source of stock selection alpha to a minority component of a portfolio has far greater structural impact than higher fees.

 

Assuming overweight position sizing relative to a benchmark is indicative of conviction level, then this research is a compelling example of the talent inherent in active managers and the alpha that is destroyed by a lack of concentration.

 

This article is one of a long series of “Empirical Proofs” of active manager skill that we’ve been collecting. To see the full list, download a full version of the Concentration Manifesto.

December 1, 2019

Capturing Alpha in Risk Rewards - Morgan Stanley

 

Morgan Stanley has one of the most robust sets of scenario-based price target forecasts in the world with around 70,000 forecasts over 10 years. Naturally, they decided to evaluate the quality of their analysts’ forecasts and the results were positive. In the chart below, their price target, scenario-based strategies consistently created positive alpha.  

 

Screen Shot 2019-11-25 at 2.18.00 PM

 

The model was built by evaluating analysts’ scenario analysis to determine buy and sell signals by using measurements and trends on the variables of Downside, Tilt, and Uncertainty. The magnitude and number of those signals determined the weighting in the hypothetical portfolio.

 

Screen Shot 2019-11-25 at 2.22.41 PM

 

They determined that there was a demonstrable benefit in using a scenario-analysis instead of a single price target.

 

Screen Shot 2019-11-25 at 2.22.56 PM

Screen Shot 2019-11-25 at 2.23.12 PM

 

Breaking the analysis down to its components (individual scenario analyses) showed consistent predictive quality from the scenarios analysis as measured by the pre-cost hit ratio (the percentage of long/short signals that generate higher/lower returns than the total return of the equity index). While a mid-50s hit rate may seem marginal, it is substantial. It is enough to create consistent outperformance, as we measured by observing our managers with consistent hit rates above 50%.

 

Screen Shot 2019-11-25 at 2.46.37 PM

 

The Morgan Stanley analysis is substantive in two ways. First, it supports our research that scenario analyses have predictive power that can be utilized to create positive alpha strategies. The second is our suspicion that buy-side manager scenario analyses are superior to sell-side forecasts because of their real-world application, their lack of administrative constraints, and lack of investment-banking conflict. If that is the case, Alpha Theory forecast dataset should have predictive power superior to that in the Morgan Stanley analysis.

 

This article is one of a long series of “Empirical Proofs” of active manager skill that we’ve been collecting. To see the full list, download a full version of the Concentration Manifesto.