Examining investment strategy can be useful when evaluating mutual funds, but what information is contained in fund holdings? Do they reveal stock-picking skill?
The first article in this series 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, while the fourth article described when stock picking works best.
Best Idea Stocks
As was argued in an earlier article, the best active equity funds consistently pursue a narrowly defined investment strategy while taking high-conviction positions in their own strategy stocks. The result is these best funds outperform. It is obvious that superior performance is the result of stock-picking skill, a conclusion documented in a wide range of studies.
It is only natural to ask if it is possible to identify high-conviction stocks, those that the investment team, after careful analysis, have selected as having the best chance of generating higher returns going forward versus those stocks with low return expectations. Disappointingly, the latter make up the majority of stocks held by the typical fund. Unfortunately, buy-side analysts and portfolio managers, unlike sell-side analysts, do not publish reports on the stocks they analyze. Instead they use this private information for their buy and sell decisions. Consequently, there is no easy route to unlock this information.
Identifying Best Idea Stocks
An interesting question is whether the size of a particular stock holding in a fund’s portfolio reveals anything useful. Can holdings information be used to identify best idea stocks and thus point to stock-picking skill?
For this to be the case, funds would have to determine a stock’s portfolio weight based on the level of conviction regarding the stock. The simplest solution would be to invest more in high-conviction stocks and less in low-conviction stocks given the incentive to generate superior returns.
Many studies confirm that alpha generating, high conviction, best idea stocks can be identified using relative, as compared to absolute, fund holdings. These studies include Chen, Jegadeesh, and Wermers (2000); Pomorski (2009); Cohen, Polk and Silli (2010); Shumway, Szeter and Yuan (2011); Wermers, Yao and Zhao (2012); and Yeung, Pellizzari, Bird and Abidin (2013).