While the active/passive debate carries on across the asset management industry, it represents only one of the questions financial professionals face when constructing portfolios for clients. Other challenges include “closet” index funds, the pressure to select outperforming managers and clients who may attempt to time the market. Even if a professional is able to steer a client away from the latter approach, he or she must still provide guidance regarding an effective combination of active and passive, or another approach to portfolio management.
With 2017’s extraordinary returns across international equity markets, investors could easily justify even more enthusiasm for passive investing. Why pay for active management when the MSCI EAFE Index is up over 25% and the MSCI Emerging Markets Index rises 37%? At the same time, most investors know that 2017’s high returns and low volatility were exactly that — extraordinary.
With the market turbulence in early 2018 adding another challenge to those noted above, we think it is valuable to take a closer look at a subset of the investment universe we call “high-conviction” (HC) active strategies and assess whether they offer measurable benefits versus index funds or low tracking error active strategies.
Defining the high-conviction universe
In this analysis, we used composite data as reported to Morningstar1 and focused on international developed markets and emerging markets. To establish a methodology for identifying HC strategies, we used five different characteristics: tracking error, beta, R-squared, upside/downside capture and active share. The table below shows the filtering guidelines for each characteristic.
From here, we established an overall HC universe by including composites that appeared in three out of the five groups created by these filtering guidelines.2 For the purposes of this discussion, strategies that fell outside of these filtering guidelines will be referred to as “non-HC” strategies.
We recognize the concern that the same historical data used to create the HC universe was also used to measure its performance. We strove to mitigate this bias by imposing a high frequency (greater than 50% for all characteristics but active share) on how often a strategy was required to meet three of the five filtering guidelines. This gives us greater confidence the strategies selected would have populated the HC universe even if other time periods were used for filtering. Survivorship bias also affects our results, as underperforming composites may have exited the universe. In a sense, however, survivorship bias gives our results a more conservative tilt due to the upward pressure on the surviving strategies to outperform the benchmark and their peers.
More in this report
- Risk/return observations
- Downside risk mitigation
- Getting in and staying in
- Patience preferred
High-conviction strategies: Investing like you mean it
Access our full analysis on high-conviction strategies here.
1 Institutional separate accounts, gross of fees, with an inception date prior to 01/02/2012. Statistics for the HC universe and all subsets are calculated using the median monthly returns from 01/01/1998 to 12/31/2017. Composite information is self-reported to Morningstar by the managers and has not been independently verified.
2 In international developed markets, 22 out of 141 strategies met the criteria. In emerging markets, 26 out of 132 strategies did so.