Why am I always beating up on passive investing? After all, even though it is not ideal, passive investing may well be better than what many retail investors would do on their own trying to invest actively. But what always irritates me is the conviction on the part of many passive investors is that it is not possible to outperform the market over time. (Just because they haven’t succeeded doesn’t make it impossible.) Well, here is some evidence about the power of good active investing. It turns out that when you look at the high conviction stock selections of good investors, they outperform by a bunch. Tom Howard of AthenaInvest points this out in a recent article:
There is, however, a group of analysts and portfolio managers who affect future stock price movements even more: the buy-side active equity managers who “put their money where their mouth is” by ranking and weighting their best stock ideas within their portfolios. A growing number of academic articles confirm that these best ideas generate superior returns. For example, Randy Cohen, et al., in.Best Ideas, show that the top relative stock pick of the typical active US equity manager generates average risk-adjusted alpha of nearly 6% annually. In another recent study, Russ Wermers et al. in The Investment Value of Mutual Fund Portfolio Disclosure, show that building a portfolio based on mutual fund holdings, weighted by past fund performance, generates an average risk-adjusted alpha exceeding 7% annually.
That’s a lot of alpha, and I think demonstrates pretty convincingly that stockpicking is not a dead art. The argument of passive investors is always this: “Great, so you can pick stocks. Why, then, do most funds underperform?” And frankly, that’s a fair question. Dr. Howard points to institutional constraints:
While the typical active equity manager overweights top picks, they also purchase less desirable stocks in order to “fill out” their portfolio. Cohen (2009) argues that this performance-destroying over-diversification is the result of powerful industry incentives, such as being paid based on AUM and being required to track an index. Thus it is also important to separate stocks held for alpha generation purposes (alpha stocks) from those held purely for diversification purposes (diversification stocks).
Sad, but true. The requirement to track an index is the bane of many managers-it’s easy to get fired for tracking error in the institutional world. The consultants that hold sway over these things have a lot to do with creating mediocre performance and with the growing tendency to do closet indexing.
As we’ve discussed before, high active share and high tracking error is associated with superior performance. If you want big numbers, you have to get out on the limb—where, sadly, no consultants are likely to follow you. In fact, they might be holding a chainsaw.
Relative strength is one of the few reliable stock selection strategies out there. It tends to generate high active share and high tracking error, along with good performance over time.
Posted by Andy Hyer 
