Naomi, an institutional active equity fund manager, typically has between 10 and 20 attractive stock ideas at any given time. But despite this, her fund holds a much larger number of stocks in order to round out the portfolio.
After asking numerous active equity managers similar questions, it became clear that they may be drowning the superior performance potential of their best ideas in a sea of bad ones. But why do they do this, and what can be done about it?
Professional Managers as Skilled Stock Pickers
The general consensus in the industry is that most active equity funds fail to meet their benchmarks. However, studies suggest that by sticking to their 10 to 20 best ideas, these managers could significantly exceed their benchmarks. In practice, though, many mutual fund portfolios hold more bad idea stocks than best idea stocks.
Collective Stock-Picking Skill
AthenaInvest rates stocks based on the fraction held by the best active equity funds. The results of this rating system indicate that the smallest market-cap quintile best idea returns far outpace those of the large-cap top quintile best ideas. The best and worst-idea stocks show significant differences in their returns.
Best Idea and Bad Idea Stocks Annual Net Returns, 2013 to 2022
According to the findings, performance declines as the best funds hold less stock. Bad ideas account for 76% of the market value held by funds, signaling a significant imbalance. By diversifying beyond their best ideas, stock pickers sacrifice performance to build bad idea funds.
Investing in Bad Ideas
While reducing portfolio volatility could be one motivation for holding more stocks, adding bad ideas beyond a certain point drags down returns without contributing much in the way of diversification. Emotional triggers, such as a desire to reduce risk, might also play a role in this behavior.
Studies have shown that mutual fund flows and performance in rational markets contribute to this return-sabotaging behavior. Investment consultants and platform gatekeepers also play a role in reinforcing these trends.
Avoiding Bad Ideas
The solution to avoiding bad ideas may seem simple but comes with its own challenges. Investing in specialized, high-conviction funds with fewer stocks and lower assets under management (AUM) might offer a way to navigate this landscape.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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