Episode 57 : 06/27/2018

Escape the index: High-conviction investing

Irina Pacheco, CFA®

Portfolio Manager & Investment Strategist
BMO Global Asset Management

Michael Swope, CFA®

Vice President, Manager Selection
BMO Global Asset Management


Ben D. Jones
Managing Director, Intermediary Distribution
BMO Global Asset Management

Emily Larsen
Product Strategy Manager
BMO Global Asset Management

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Recently, some investors and advisors have thrown in the towel on active management and are questioning if there is still a place for it in portfolios. According to a recent research paper, high-conviction equity managers may still add value in terms of return potential and risk mitigation.

We’re joined by the authors of the paper, Irina Pacheco and Michael Swope, to discuss the role that high-conviction strategies can play in a client’s portfolio and the research behind High-conviction strategies: Investing like you mean it.

In this episode:

  • What Irina and Michael found in their research
  • How financial professionals should approach high-conviction managers
  • The pros and cons of high-conviction managers inside a client’s portfolio
  • Due diligence in strategy and manager selection remains key
  • Patience can be rewarded over a long market cycle

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Irina Pacheco – Invest like you mean it. Have high conviction in your high-conviction managers as they can out-perform over a long market cycle.

Ben Jones – Welcome to Better conversations. Better outcomes. presented by BMO Global Asset Management. I’m Ben Jones.

Emily Larsen – And I’m Emily Larsen. In each episode, we’ll explore topics relevant to today’s trusted financial advisors, interviewing experts and investigating the world of wealth advising from every angle. We’ll also provide you with actionable ideas designed to improve outcomes for advisors and their clients.

Ben Jones – To access the resources we discuss in today’s show, or just to learn more about our guests, visit bmogam.com/betterconversations. Again, that’s bmogam.com/betterconversations. Thanks for joining us.

Emily Larsen – Before we get started, one quick request. If you have enjoyed the show and found them of value, please take a moment to leave us a rating or review on iTunes. It would really mean a lot to us.

Disclosure – The views expressed here are those of the participants and not those of BMO Global Asset Management, its affiliates, or subsidiaries.

Emily Larsen – Today we’re discussing the role high-conviction managers can play in a client’s portfolio. Our two expert guests recently co-authored a paper titled High-conviction strategies: Investing like you mean it.

Ben Jones – I sat down with Michael Swope and Irina Pacheco, both who are members of BMO GAM’s Multi Asset Solutions team. We connected in the Chicago office where we discussed what they found in their research, how financial professionals should approach high-conviction managers and the pros and cons of high-conviction managers inside of a client’s portfolio.

So we’re here today and we’re talking a little bit about a paper that you guys co-authored this spring around high-conviction managers and their place inside of a portfolio and I enjoyed the paper for two reasons. One, I thought it was really thoughtful but also I thought the length was digestible. Kudos to you guys because you don’t always get that. Sometimes you get these academic papers and you finish them and go I have no idea what they just said. So congratulations on finishing the paper. I was wondering and I’m not sure who the right person is but if you could just tell me a little bit or both of you jump in and tell me a little bit about kind of the genesis of the idea.

Michael Swope – I think there’s been a lot of papers and discussions about active management and passive management. we wanted to take a little bit of a different approach and not just look at active but look at high active or what we define as high conviction. I think that’s a little unique to what we’re looking at. there’s a lot of papers that have to deal with domestic equity and so we looked international — both international developed and emerging markets.

Irina Pacheco – Also, as an overarching rule, we do not make investment decisions based on conventional wisdom unless we test it. Since there has been a lot of discussions like Mike said recently about active and passive investments with an emphasis on diminishing benefits from active management, we wanted to check the validity of the statement and approach it a bit differently.

Ben Jones – Why do you believe that professional buyers should be interested in this research?

Michael Swope – couple of reasons why. One, I think it has a compelling argument. It has empirical evidence that lays out that these high-conviction managers do add value in terms of return, in terms of risk, and then it also has some rationales or specifics about long-term investments and staying patient. So I think that’s important. But I also think we also did a nice job of creating a framework to produce a sub-universe for high-conviction managers so that when you’re selecting a manager to put in a portfolio we put together a nice framework and a way to do that either exactly or you can use this again as a framework.

Ben Jones – So Mike, I think you touched on this. A lot of people have kind of thrown in the towel on active management when building out their allocation models or have maybe in certain asset classes have gone past it. Why do you believe so many allocators have gone to these types of passive implementations of their allocation ideas?

Michael Swope – Let’s be honest. I think passive in the structures that they’re in either in mutual funds or ETFs that is an efficient way and a cost efficient way of capturing beta of an investment category. The fee pressures that we’re seeing throughout the industry is also a factor. I know for sure one way to increase your return — this is almost like one of the only guarantees in investments — is to reduce your fee. I think that adds to it. The proliferation and ease of use of ETFs also has played into it. Let’s also be honest with ourselves. There’s been a long period of time where active has under-performed significantly over the last number of years. That’s changing but I think that also adds to the use of passive either through mutual funds or ETFs.

Ben Jones – You guys alluded to this earlier, but you really set out to define a systematic way to define a universe of what you call high-conviction managers. Irina, could you just walk us through how you went about this process.

Irina Pacheco – Yeah sure. In my view, a high-conviction manager is characterized by a less constrained view on markets and it takes above average bets versus the bench. But I don’t believe there is a single perfect quantitative metric that measures this investment approach. However, there are many good metrics that could do that. So in very broad strokes, related to our approach to constructing this high-conviction universe, we started from the full universal strategies within the same family and we calculated five different metrics over a three-year rolling window and flagged those strategies that consistently were in the top or bottom quartile depending on the metrics used. In essence, this resulted in five groups of strategies from which we constructed the high-conviction universe by selecting the strategies that populated the three out of the five groups. So those groups were tracking error, beta, upside/ downside capture ratio, R-squared and active share.

Ben Jones – Were you weighting those differently as far as their importance or equal weighted in the way that you screen them?

Irina Pacheco – We detail it a little bit more in our paper the exact criteria used, but we put a high frequency threshold on how often these criterias were met. We wanted the managers to meet these criterias at least 50% of the time and when you look across the five different groups, we wanted the resulting universe to be constructed of managers that populated at least three out of the five.

Ben Jones – One of the metrics you used is active share, and Mike, active share is like a buzz word for the last several years in our industry. Why do you think active share as a screening criteria has gotten so much attention?

Michael Swope – I think first, it’s a statistic that’s relatively new. It’s only been around since 2009. I also think the active share is a benefit of the advancement of technology. It’s a calculation where you have to compare the constituents of both your portfolio and the constituents of the index but today using some services like a Morningstar you can relatively easily calculate active share and there’s some intuitiveness to active share. If you are the index, you’re not going to beat the index, so more different you are than the index the potential of producing alpha. the statistic is a valid one. It has empirical evidence that shows that if it’s a high active share that has a propensity to out-perform the index.

Ben Jones – And maybe in layman’s terms just for the listener base, could you maybe just kind of describe what active share is intuitively, non-textbook definition.

Michael Swope – I’ll tell you exactly what it means in terms of the numbers. It’s 0-100. If you are a 0 active share, you are the index. If you are 100, you don’t have any similarity to the index.

Ben Jones – Now people sometimes confuse that as we’ve got high active shares, so this is a good manager. You can have high active share and always pick wrong, correct?

Michael Swope – Correct. picking a high active share manager doesn’t necessarily mean you’re picking a skilled manager. It just means you’re picking a high active share manager.

Ben Jones – So with respect to that, Irina, is that the reason that you added in the paper so many other metrics to layer in on top of that.

Irina Pacheco – That is correct. So we didn’t want one single metric to dominate our universe construction. We also don’t believe that one single metric is the best, like I stated earlier. So we wanted to have a range of metrics, each of them tells us something a little bit different about the manager but in combination they help us define what a high-conviction universe looks like.

Michael Swope – We spent a lot of time discussing and trying to determine what that grouping of statistics were and looking at the data to make sure that we are getting a robust enough subset of managers that are high conviction.

Emily Larsen – As an aside, you can download Irina and Mike’s paper at bmogam.com/betterconversations. If you go there now, you can review it while listening to the rest of the episode. Now that you have an overview of their thesis and how they went about constructing a high-conviction universe, let’s look at some key insights their research uncovered.

Ben Jones – Mike, what did you find were some of the key insights when you kind of evaluated this universe?

Michael Swope – A couple of items that bared out in the study and that is that high-conviction managers over the long-term does have higher performance, higher return.

Ben Jones – Define long-term.

Michael Swope – I think we are looking over 20 years and we looked over rolling three, five, and ten year periods in our study, so at least a market cycle and some of our calculation much longer than that. What I think was interesting that we found out was these high-conviction managers over the long-term also had better downside risk mitigation which is kind of counter intuitive at least when you think about high conviction you think of higher volatility and I would agree with that at least over the short period of time, but over the long period of time, our studies show that it does — these high-conviction managers on average do hold up better. And then the other item that I found interesting in the study was the tendency of high-conviction managers to rebound strongly after a period of under-performance. So going from a bottom quartile ranking to a top quartile ranking, the high-conviction managers did a better job of that upswing relative to the non-high-conviction managers.

Ben Jones – Very interesting.

Michael Swope – Again, at least providing some evidence to stay the course and be patient.

Ben Jones – You guys put together this original thesis and this idea as you laid out. I’m curious from the original idea what did you learn after doing the research that maybe changed or changed your mind as you kind of dug into this process.

Michael Swope – I for sure thought preconceived notion that there was going to be higher return which absolutely was born out in the research, but that again lower volatility when you look at the graph with a return on the Y axis and risk on the X axis are data points relative to the overall universe and the index was north and to the left. So looking at that graph of risk return, it clearly shows that our high-conviction managers do have higher return and lower volatility relative to the index and its peers.

Ben Jones – That is a little bit shocking. I would have expected, as you, a lot more volatility in the returns but as you said that patience over the long-term kind of delivers different results than you might expect.

Michael Swope – And the other thing that I found interesting was we talked about those managers that went from poor performance to improved performance, so bottom quartile to top percentile. We also looked at managers when you hit the top quartile, what was the chance of it going to the bottom quartile. We actually found that high-conviction managers actually held up better in especially the international developed universe than the non-high-conviction managers. Which then again is kind of counter intuitive because you would expect that the high-conviction managers have this higher volatility but I would also say that our period was not one month, six months, one year. It was a three-year time period which allows that high-conviction manager to perform better over the long-term.

Ben Jones – I really liked the way you did the rolling analysis as well, so you kind of start to eliminate kind of the time period bias of —

Irina Pacheco – The noises, yes.

Ben Jones – That’s a better way to say that. The other thing I thought was really clever in the paper is that you guys not only showed your analysis relative to these indexes in these categories, but also into what you could actually invest in, being an ETF of the index or a low cost index fund which I think people tend to forget that you can’t actually buy the index for free exactly yet. We might be on our way there, but at the moment — and I thought that was really clever to show this is what your choices are. You can invest in this or this and it was a nice comparison. Now, I want to get to what the financial professionals that listen to this show should do with this information. And so let’s maybe first start with the allocators, and this is kind of your area of expertise, Irina. So based on allocation, how would you go about allocating to a high-conviction manager inside of a portfolio.

Irina Pacheco – Well Ben, I think that this is — this decision should be done on a case by case basis. It is important to know what the specific allocation is meant to achieve. What’s the investment objective? How does this allocation sit within a broader portfolio structure? If we’re talking about multi assets in general. When you are looking at combining a passive investment with a high-conviction manager, you want to know whether you are balancing your factor exposures the right way. In our analysis we used a very simplistic 50/50 allocation just to give our readers some idea of what type of results they can expect from adding a high-conviction manager in their portfolio. But I feel it’s up to them to take this analysis a step further and examine how a specific manager that they would choose from this high-conviction universe would work with another allocation they have in that same asset family. So it provides a guide to creating this universe from which they could select a high-conviction manager but it doesn’t address more of the in-depth question of portfolio construction.

Ben Jones – Those always in the details, right?

Irina Pacheco – Correct.

Ben Jones – Now, Mike, I would like to get — add on to that but also just talk about how this might change the way you go about selecting or identifying managers.

Michael Swope – I’d like to take it from a little bit of a different angle, and that is we all know fees are important, fees are becoming more and more important. And so you can look at this paper as a better way of spending your fee budget to the client. And we would argue you don’t necessarily want to allocate a high fee budget to a potentially — an index hugger where they’re not going to have a good potential of out-performing that fee, so by creating a framework that allows you to concentrate on managers that are considered high conviction, which would then follow that you have the ability to produce a higher alpha, then you may want to think about using this universe or framework of spending that fee budget to this type of universe.

Ben Jones – With the fee budgeting approach, I’ve always found as a really fascinating way to think about portfolio construction. You have kind of a set of this is about how much an investor can afford to pay in fees and then you allocate that budget to deliver the highest possible outcome over the investment period of time and so I noticed in the paper you don’t necessarily suggest spending all of the fees on a high-conviction manager in these categories. Your analysis, you do a blend, and that actually delivers kind of a maybe a little bit better result to keep people invested. So talk me through how that came about or that thought process.

Michael Swope – it’s important not to be undiversified, and this type of strategy allows you to diversify into passive which works in certain markets, especially up markets. And active provides the opportunity to produce alpha and also diversifies your expense budget where you’re spending little money on capturing the beta of the portfolio and then you’re using a higher expense ratio manager or higher expense manager to create that alpha or and better yet risk adjusted returns that give a better outcome for your client’s portfolio.

Ben Jones – Patience is a virtue and it may not be a virtue that all of your clients possess. For advisors, understanding these topics is well and good, but the hard work lies between making the investment decision and helping the client understand why that manager or investment decision makes sense for them. This is particularly true when asking a client to invest in an under-performing or bottom quartile manager.

Irina Pacheco – Going back to your original question: How would the asset allocators use this information? I think that another important point to make here is that like I said earlier this filtering criteria help identify the active managers but in regards to manager selection the analysis highlights the point that just like with any security, buying a strategy at the bottom may not be such a bad idea. Poor performance should not detract from investing in a particular strategy, as is evidenced by the higher probability of rebound of the high-conviction strategies versus the non-high-conviction strategies. So I just wanted to emphasize the idea of not only staying invested but also buying at the bottom, a high-conviction strategy.

Ben Jones – That’s one of those things that’s easy to talk about but really hard to convince clients why they want to buy the fourth quartile high-conviction manager.

Irina Pacheco – Precisely but I feel like this analysis supports that argument.

Ben Jones – And so do you have any suggestions on how an advisor or financial professional could speak with their investors about this in a way that helps them get comfortable with the thought of buying at the bottom.

Michael Swope – we lay out some empirical evidence that is proven to offer patience as an attribute of investments that does pay off in the long run. I know it’s hard. There’s a lot of emotion that goes into investments, but to have this analysis could allow you to have a tool to show your clients that long-term patience is a virtue that you need to expand in your portfolios.

Ben Jones – I forgot to ask you this earlier, so just to circle back to something. When you created the universe, how many were in that and then how many ended up in this high-conviction universe?

Irina Pacheco – It was not a universe of funds but a universe of composites, so for international developed equities, we looked at 141 strategies and we identified 22 of them as high conviction which represent about 15% of the total universe. For emerging markets, we looked at 132 strategies and we identified 25 of them as high conviction, so roughly about 20%. So this further underlines the benefit of this paper because it offers an approach to filter the universe and narrow it down to a manager by number of strategies such that the managers due diligence group of an individual firm could focus on a much narrower pool of strategies in order to pick the right one. Our approach helps create this universe but it is up to the particular firm to do their due diligence and identify the actual strategy that goes in a portfolio.

Michael Swope – I think that’s really an important point. We’ve created a sub universe of high-conviction managers. You still cannot replace the selection of a skilled manager. That still needs to be taking place but you’re going from 100 plus to 20 or basically top 20% of these universes which sounds about right in terms of what high conviction versus the relative universe but you can’t just then select quantitatively the median manager of that space. You still have to do additional research and then let’s also understand there’s differences between those high-conviction managers and depending on the need of the client and what you’re trying to do in the portfolio has to come into account.

Emily Larsen – Just to interrupt here. You may want to take special note of Mike’s next piece of advice on how to denote and explain high-conviction managers to your clients.

Michael Swope – Each product or manager plays a certain role within a portfolio and labeling them as high conviction may offer the idea that this manager deserves more patience because of the short-term under-performance but as we’ve said numerous times, this idea of rebounding over a three-year period you have a high probability of north of 70% of that occurring and what’s the chance of you as an investor selecting a manager that is going to be a 70% chance of being in the top quartile three years post. I’ll just leave with my three takeaways. And that is I think our paper shows empirical evidence that high-conviction managers can improve a portfolio’s outcome. I also want to just highlight again the framework in which we — used to create a high-conviction universe. I think that was another important takeaway. And then this idea of patience; the investment attribute of patience is an important one that I think our paper hits on in the right tone.

Irina Pacheco – I take it from a more quantitative perspective and I would say, one, high-conviction strategies form a quantitatively identifiable subset of a universe of active strategies. And two, invest like you mean it. Have high conviction in your high-conviction managers as they can out-perform over a long market cycle.

Ben Jones – What does it feel like when a financial professional gets these decisions right?

Irina Pacheco – Obviously, it feels great. And you feel that the reward for the work you’ve done to do that analysis, the thought process putting into this pays out when you look at performance.

Michael Swope – I’m going to jump in here and what I want our listeners to gain out of this is the confidence that their investment philosophy is a good one and that they should stick to their investment philosophy which they built into which again ties back to this whole idea of patience.

Ben Jones – Irina, if you were to put a warning label on our discussion today, what would it say?

Irina Pacheco – I would say the analysis focuses on median performance. I wanted to make that clear – the median performance of this high-conviction universe that we created. But in real life, there is a range, and any high-conviction strategy’s performance might be different than the median at any given point in time. So due diligence in strategy and manager selection remains key.

Emily Larsen – I want to reiterate the final takeaways that Irina and Mike highlighted. First, the paper shows how a high-conviction manager can improve portfolio outcomes. Second, it provides a framework that can be used to create a high-conviction sub universe that you can then use to perform your qualitative due diligence in order to select a high-conviction manager. Third, patience. Patience is a virtue and with high-conviction managers you’re likely going to see a reward from the longer investment timeframe. Fourth, consider literally labeling high-conviction managers as such for your clients so they know to treat them differently than a more traditional approach. Finally, Irina urges advisors to have high conviction in your high-conviction managers because they will reward you for your patience over a long market cycle.

Ben Jones – To explore the research and analysis referenced in this episode, including an interactive comparison chart for high-conviction managers, follow the links in the show notes or go to bmogam.com/betterconversations. Mike and Irina, thank you for joining us on the show today and sharing your research and ideas.

Ben Jones – Thanks for listening to Better conversations. Better outcomes.  This podcast is presented by BMO Global Asset Management.  To learn more about what BMO can do for you, visit us at www.bmogam.com/betterconversations.

Emily Larsen – We value listener feedback and would love to hear what you thought about today’s episode, or if you’re willing to share your own experiences or insights related to today’s topic, please e-mail us at betterconversations@bmo.com.  And of course, the greatest compliment of all is if you tell your friends and co-workers to subscribe to the show.  You can subscribe to our show on iTunes, Google Play, the Stitcher app, or your favorite podcast platform.  Until next time, I’m Emily Larson.

Ben Jones – And I’m Ben Jones.  From all of us at BMO Global Asset Management, hoping you have a productive and wonderful week.

Emily Larsen – This show and resources are supported by a talented team of dedicated professionals at BMO, including Pat Bordak, Gayle Gipson, Matt Perry, and Derek Devereaux.  This show is edited and produced by Jonah Geil-Neufeld and Annie Fassler of Puddle Creative.

Disclosure – All investments involve risk, including the possible loss of principal. Future investment performance cannot be guaranteed. Diversification and asset allocation do not ensure a profit or guarantee against loss.

The views expressed here are those of the participants and not those of BMO Global Asset Management, its affiliates, or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, or security. This presentation may contain forward-looking statements. Investors are cautioned not to place undue reliance on such statements, as actual results could vary. This presentation is for general information purposes only and does not constitute investment advice and is not intended as an endorsement of any specific investment product or service. Individual investors should consult with an investment professional about their personal situation. Past performance is not indicative of future results. BMO Asset Management Corp is the investment advisor to the BMO funds. BMO Investment Distributors LLC is the distributor. Member FINRA/SIPC. BMO Asset Management Corp and BMO Investment Distributors are affiliated companies. Further information can be found at www.bmo.com.

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