This week’s blog is written by portfolio manager CJ Cowan
What happens when just a few stocks drive market returns? CJ Cowan explores the fine line between skill and luck in active management - and why missing a handful of outperformers can make all the difference.
Recent conversations with UK equity managers have revealed a recurring theme: it’s not what they held that hurt performance, but what they didn’t. This is in reference to performance compared to their benchmark - if you don’t own a stock that’s a big weight in the benchmark and it goes up, or if you don’t own a stock that’s a smaller weight in the benchmark and it rises sharply. Either way, this drags on relative performance. You hope the positive returns from the stocks you do own outweigh this, but it won’t always work like that.
Is there a reason why we are hearing comments like this more frequently? Or are they just excuses? To answer this question, we can consider how concentrated the return drivers of the UK equity market have been.
So far this year, the MSCI UK All Cap index has returned 14%, and the top 3 contributors, Rolls Royce, HSBC and British American Tobacco, are responsible for 5% of that 14%. Rolls Royce contributed 2% on its own, having delivered stratospheric share price growth. Including its dividend, the total return exceeds 90%.
While it’s not unusual to see a dispersion in the fortunes of companies, and indeed this is exactly what active managers aim to capitalise on, when benchmark returns are dominated by a small number of stocks, it makes outperforming very dependent on whether you own these stocks or not.
Any (sensible) fund manager will tell you that diversifying your bets across different stocks and themes with distinct return drivers gives you the best chance of delivering good returns while appropriately managing risk. However, there will always be a more concentrated portfolio you could have held that would have delivered higher returns. If, on January 1st, you know Rolls Royce will return over 90%, then why would you buy anything else? Of course, you don’t know this, so diversifying across several stocks is a much better way to avoid significant portfolio risk.
Meanwhile, any self-aware fund manager must also acknowledge the role of luck in their investment outcomes. While a taxi driver with only a 60% hit rate of getting their customers to their destination would be derided as the worst taxi driver in the world, a seasoned investor with a 60% hit rate on their stock ideas would be lauded as one of the best of all time. This is because there are so many unknowable factors that can dominate stock prices, whereas when driving a taxi, the chance that skill leads to a positive outcome is a lot higher.
Joining the dots, you can see that if only a few stocks dominate benchmark returns, then only a few decisions to own or not own them can be the swing factor in whether you beat your benchmark. If you layer on top the idea that even the world’s greatest investors only get a little more than half of their calls right, then you can see how easy it could be for this handful of big outperforming stocks to be part of the portion of calls a fund manager gets wrong.
Concentration of equity returns isn’t a new idea - it has been a hot topic over the past decade as a relatively small number of US tech stocks have dominated global equity returns, but it is an issue outside of the US as well. When we consider whether managers in our portfolio genuinely possess skill, the way benchmark returns have been delivered is an important input into our assessment. If benchmark returns have been very concentrated, then we are more likely to be understanding of disappointing performance.
CJ is a portfolio manager of the Quilter Investors Cirilium and Monthly Income Portfolios. CJ joined Quilter Investors in August 2018 from Aberdeen Standard Investments where he worked in the global macro team, managing global government bond and global aggregate portfolios.
CJ is a CFA charterholder and has also completed the Chartered Alternative Investment Analyst qualification. CJ has a degree in economics from the University of Bristol and an MPHil in Economic and Social History from Brasenose College, University of Oxford.
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