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Active managers, particularly in the equity arena, have taken their lumps, but not all active managers are duds. Plenty have enviable long-term track records and there are environments in which in this style can be equally as fruitful for clients or even more so than passive management.
Perhaps not surprisingly, data indicate that some of the more successful active managers are the ones that make large bets. Or, in fancier financial parlance, they take high conviction positions, assigning large percentages of an equity-based fund to a small number of holdings.
There are regulatory guidelines that clarify large equity wagers. For example, the 1940 Act states that a fund cannot allocate more than 25% of its assets to positions that account for 5% of the fund’s weight. So a $1 billion fund can devote just $250 million of its capital to holdings that each represent 5% or more of the roster.
Liberties can be taken if the fund is smaller or if the managers wants to, say, have three positions of 8% apiece. Eight percent certainly fits the bill as “high conviction.”
More Managers Making Bigger Bets
For advisors that favor active management with stocks, take note that the number of active managers embracing large positions is increasing.
“If you go back to 1997, 3% of portfolio managers had what I define as a big bet in their portfolio. Fast-forward to 2023, you had 14% of managers doing it, so more than a 4x increase,” observes Jack Shannon, Morningstar Research Services’ Senior Manager Research.
Last year was a case study in some active managers upping the number of large positions in equity portfolio and the success of the magnificent seven stocks easily explains why. Those seven high-octane names account for a significant percentage of the S&P 500’s gains in 2023 – some might say too much – and fund managers that were marketweight or underweight some or all of those stocks risked delivering subpar returns to investors.
Middling returns when mega-cap stocks are flourishing leaves advisors with explaining to do because they’re the ones that have to personally interact with retail clients. Speaking of clients, for some, the tough pill to swallow is that big bets that are successful aren’t guarantees of impressive gains for the fund at large.
“So, if you look over the holding period of the stocks, roughly 60% of the bets paid off. What that means is over the holding period, the stock beat the underlying benchmark. So, it was a winner,” adds Shannon. “Over those same periods, though, the funds themselves, only 33%-ish—I feel like 37%—but only about a third beat the benchmark. So, there’s this conundrum of you’re betting on these winners, but yet you’re still underperforming.”
Big Bets Don’t Always Matter
Sure, it’s eye catching to look at a fund’s holdings – active or passive – and see percentage such as 5%, 8% or more assigned to a single component. However, those positions, even when they’re winners, don’t guarantee overall success for the fund.
Translation: Funds that didn’t have big bets that lagged their benchmarks would have trailed even with a couple of highly concentrated positions while those that beat their benchmarks would have done so without the assistance of a big bet.
“On the other side, if you look at the stocks that did outperform the benchmark, 75% would have outperformed the benchmark even without the bet,” concludes Shannon. “So those were funds where the managers were picking good stocks throughout the portfolio and didn’t even really need the big bet to get that index-topping performance. That was one of the key takeaways is that you need good stock-picking throughout a portfolio, and you can’t really rely on one big bet to swing the outcome one way or another.”
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