Portfolio Management in the Active Equity Renaissance

Capitalization is entirely arbitrary as a style box. It is a relative delineation of active funds that has little to do with the equity strategies being pursued. The universe of securities is divided into market capitalization thirds, with the smallest third categorized as “small,” the largest as “large,” and everything in between as “mid.” This becomes the measuring stick for manager style drift and often has no relation to the actual management of the portfolio.

The value-core-growth style box is also relative. The book-to-price ratio is calculated for an index, with the highest book-to-price ratio labeled “value.” The lowest book-to-price ratio is called “growth.” Those in the middle are “core.” Once again, management evaluates funds to a standard with little bearing on security selection or portfolio construction, but on securities price movements, which are notoriously volatile.

Managers who want to hold on to the AUM that comes through investment intermediaries must adjust the composition of their portfolios as markets change. Why? Because tracking error, style boxes and style drift tell investment intermediaries that something is “wrong” and may lead to the assets being pulled from the manager.

In fact, some see style drift as a graver offense than underperformance. Consequently, managers engage in a form of investing legerdemain, or sleight of hand, that has nothing to do with executing their strategy and everything to do with placating investment intermediaries.

How to Engage in Renaissance Portfolio Management

Focus on high-conviction stocks. Studies show that buy-side analysts are quite good at security selection: Take, for example, the high levels of accretive alpha of their highest conviction/largest positions, as measured by ex-ante relative portfolio weights. Moving down the relative weights, performance worsens, with holdings beyond the top 20 generating negative alpha. In other words, most portfolios are overdiversified and research shows that hurts performance.

This creates a problem for the successful manager who receives large investment flows when performance is good. Due to legislative requirements like the U.S. Investment Company Act of 1940, maximum position sizes — as measured by cost basis — force managers to invest in securities in which they have less conviction.

Convert to an index fund. Managers who invest in securities they don’t believe in to avoid cash positions — remember that style drift problem! — should consider converting to an index fund if AUM grows too large. How large is too large? Research suggests that AUM close to $1 billion is too large for investment managers. Capping new inflows is also an option. Some funds do this to ensure that their security selection is built around high-conviction positions.

Introduce performance-based fees. Another way to engage in renaissance portfolio management: Introduce performance-based fees. We are strong advocates for high-watermarking fees and performance.

There is a theory that active managers perform better during periods of overall market decline. One way to leverage that is to alter the fee structure to encourage neutral to positive returns in down market periods. If a manager cannot deliver better than a benchmark — say, a highly rated sovereign credit’s return over a similar time horizon — then they shouldn’t be paid for their performance.

Dismantle the Closet-Indexing Factory

The vast majority of active equity investment teams are skilled stock pickers. However, many funds transform into closet indexers through asset bloat, benchmark tracking and overdiversification. Essentially, the industry is a giant closet indexing factory. Funds are strongly incentivized to capture the economic rents generated by their investment teams.

Once the fund becomes a closet indexer, powerful incentives encourage it to stay that way. Today, closet indexers harvest internal cash flows amid strong outflows. Why would these legacy funds restructure into truly active funds when it may be more profitable for them to simply wither away?

Our best hope is to steer new entrants away from becoming value-destroying closet indexers. Dismantling the finance industry’s closet indexing factory is a critical step in the active equity renaissance.

— Read Gundlach: Robos Could Cause Next Crash; Passive Mania Will Wane on ThinkAdvisor.