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In recent years portions of the fund management industry have been accused of ‘closet indexing’. That is, some funds have been found to be indistinct from the benchmarks they aim to beat yet charge a high fee for this supposedly ‘active’ management of a portfolio. In response, asset management groups have taken to profiling the ‘active share’ of their funds. This is a holdings-based measure of how significantly a portfolio overlaps with its benchmark: owning fewer stocks drives higher active share.
My ventures are not in one bottom trusted,
Nor to one place, nor is my whole estate,
Upon the fortune of this present year.
Therefore my merchandise makes me not sad.
Active share, however, is not a panacea for performance, as it simply increases the statistical likelihood that portfolio returns will deviate from those of an index without indicating whether that performance is positive or negative. Stockpicking ability is required to increase the chance of a beneficial outcome.
Yet the uncomfortable truth is that most stocks are losers, failing to beat cash, because the distribution of individual stock returns is non-normal, with very fat tails. One study has found that the entire gain in the US stock market from 1926 to 2015 can be attributable to just the top-performing four percent of listed stocks.1 How, then, to balance this tension: on the one hand, fund managers must create concentrated portfolios with high active share; on the other, the fewer stocks they hold, the less likely they are to own some of the very big winners?
Studies have shown that funds which combine high active share with low turnover have a propensity to outperform.2
We contend that there is something about asking the simple – but not necessarily easy – question, ‘am I willing to own to own a lot of this stock for potentially a very long time?’ which itself becomes a source of analytical advantage. It focuses the investment debate and leads practitioners to play a different game.
On a month-to-month basis share price returns are dominated by fluctuations in the valuation multiple driven by market sentiment. News-flow and emotions are inherently unpredictable and difficult to anticipate. In contrast, over a multi-year period the valuation multiple becomes overwhelmed by corporate performance measured in changes to returns on capital and cash flow.
Forecasting future business fundamentals is generally fraught with difficulty. Accordingly, our investment approach seeks out opportunities where islands of relative predictability exist, that enable us to narrow the widening cone of uncertainty that inevitably widens out as one extends time horizons.
Trends like cloud connectivity, electric locks and biopharmaceutical process manufacturers are current examples of themes that have an element of predictability baked in to them. In the case of cloud computing and electric locks, this predictability comes from an inevitable trend being replicated geographically. However, in the case of biopharmaceutical process manufacturers, predictability can be achieved by staking investment further upstream from initial development of drug products – thereby reducing risk.
