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1 July 2015 CFA Institute Journal Review

No Fear of Commitment: The Role of High-Conviction Active Management (Digest Summary)

  1. Sridhar Balakrishna

Investment strategies and return outcomes can be different for asset managers and investors based on the factors of diversification and active management. Both factors play vital roles in investment management because investors need to combine high- and low-active-risk managers along with index funds to diversify their portfolios, whereas investment managers do not necessarily need to.

What’s Inside?

The authors discuss the balance between diversification and specialization from the perspective of asset managers and investors. They contest the view that investment managers should always diversify, and they express the need for managers with specific skills and knowledge to specialize. The authors also discuss the criteria for the selection of active asset managers.

How Is This Research Useful to Practitioners?

Using the concept of bounded rationality, the authors establish the behavioral case for specialization—that is, a manager cannot be multi-skilled on most occasions and can be limited in terms of specialization to only a few areas. Also, it is rational and cost efficient for a manager not to try to obtain all the information primarily because of the amount of time it takes to interpret the information.

The authors note that it is in the investors’ interest to diversify their portfolio risks between a multitude of high-conviction and generalist active managers and index funds. Investors should primarily focus on separating their beta and alpha decisions—beta decisions based on the asset classes they decide to hold and alpha decisions based on the selection of skillful active managers who can outperform the relevant benchmark.

Furthermore, the authors claim that although diversified active funds are cost efficient with low active risk, high-conviction active funds add the skill element that results in higher overall portfolio efficiency.

The authors detail the process that investors should adopt in selecting high-conviction active asset managers—people, investment process, screening, portfolio construction, risk management, and performance evaluation.

How Did the Authors Conduct This Research?

The authors believe that investors should maximize the information ratio, which is a combination of manager skill (measured by the information coefficient) and breadth of assets covered, and not use raw alpha as the decision criteria. The authors present this view by considering manager and sponsor portfolios studied earlier by Clifford, Kroner, and Siegel (Investment Insights 2001).

Investors are usually risk averse and will require higher alpha per unit of active risk over the benchmark. The authors refer to another study that showed that high-active-risk managers beat low-active-risk managers in the same asset class over a 10-year period ending March 2010. But the results of this test could be affected by survivorship and/or selection bias.

They definitively lay down the criteria for selecting high-conviction active managers and the impact they would have on long-only and long–short investing strategies. Investors need to consider their personal situation and objectives when deciding the asset class mix and expected net returns to meet these objectives.

Abstractor’s Viewpoint

Although the authors focus their study on high-conviction active investment management, they explain the principles and processes required for investors seeking active returns. They emphasize that it is prudent to select a mix of active managers and index-hugging managers rather than select a group of either diversified or active managers separately. This approach could result in the investment strategies cancelling each other out and not providing the intended diversification benefits.

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