Enhancing Long Only Equity

Simple Yet Effective Ways to Enhance Long Only Equity Management

This Morningstar article (Morningstar on Current Asset Management Trends) really does a great job of summarizing the state of the Asset Management industry and some of the pressures faced by all firms. Asset attrition from traditional Long Only Equity to lower fee Quant and ETF product has put unprecedented pressure across the industry. As a career risk professional who has spent a tremendous amount of time working on Long Only equity, I have had a ringside seat to many of the internal challenges faced when managing and overseeing Equity portfolio managers. One ubiquitous issue is that many portfolio managers view security selection as the exclusive source of alpha within a portfolio. Even in portfolios that are primarily based on security selection you can harvest tremendous additional alpha by running a more rigorous overall process. Refinements and improvements in backtesting, screening, portfolio construction, and position sizing can all be massively beneficial.

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Backtesting Variables

1.????? Backtesting is often used as a marketing exercise rather than a robust portfolio management tool.

2.????? It is essential for designing effective equity portfolio management strategies. Without rigorous backtesting, it is impossible to gauge the statistical efficacy of stock selection criteria, which can lead to subpar investment decisions and suboptimal performance.

3.????? Even the most intuitively appealing strategies need thorough statistical analysis to estimate their expected efficacy. Backtesting simulates how stock selection criteria would have performed historically, providing a clearer sense of their potential effectiveness and reliability in different market scenarios.

4.????? Backtesting reveals the specific market environments where criteria tend to outperform or underperform. This insight is invaluable as it informs other aspects of the investment strategy, such as identifying the market contexts in which the selected criteria should be applied more judiciously.

5.????? Backtesting should not be a one-time process but a dynamic mechanism that is periodically updated to ensure criteria remain relevant and effective. Market environments are constantly changing, and what worked in the past may not necessarily work in the future. Regular updates allow investors to adapt their strategies to reflect current market conditions, maintaining the robustness and adaptability of the investment strategy.

6.????? This ongoing reassessment helps in fine-tuning the approach, ensuring that it continues to deliver optimal results over time. By regularly revisiting and updating backtesting procedures, investors can ensure their strategies evolve with the market, leading to more consistent and reliable performance.

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Alpha from Screening

1.????? Screening is crucial in portfolio management as it ensures that the stocks evaluated for potential inclusion meet the requisite criteria. By filtering out securities that do not align with predefined metrics, screening helps maintain the quality and consistency of the investment process.

2.????? One key pitfall of screens is that they are not inherently responsive to changing market conditions. A common error portfolio managers make is holding onto stocks that no longer pass the screening criteria, often due to the sunk cost fallacy. This mistake can hinder portfolio performance and deviate from the intended strategy.

3.????? The results of the screen can be treated like a portfolio itself. Firms can create an equal-weighted portfolio from the stocks that pass the screen and monitor its performance relative to the actual portfolio. This allows managers to assess whether they are adding value beyond the initial screen.

4.????? Screens are not just for stock selection but also for refining and improving the overall investment process. By using screens to regularly revisit and adjust the investment strategy in response to market changes, managers can enhance both the efficacy and adaptability of their strategies. This ensures that the portfolio remains aligned with its strategic goals and can adapt to evolving market conditions.

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Managing Position Sizing

1.????? Position sizing is a critical aspect of portfolio management, yet it is often based on traditional heuristics. Common methods include setting fixed ranges, such as 0.50% to 5.0%, or relying on upside estimates derived from bottom-up analysis. However, these approaches have significant limitations, as bottom-up upside estimates themselves are subject to error, which can lead to misinformed position sizes.

2.????? Traditional methods frequently do not account for the absolute volatility of the assets or their contribution to active risk. Absolute volatility is crucial because it affects the overall risk profile of the portfolio. Ignoring the contribution to active risk means overlooking how individual positions influence the portfolio's deviation from its benchmark.

3.????? Traditional heuristics also often do not consider the factor implications of position size. This can result in unintended exposures to market risks, such as macroeconomic or stylistic factors, that are not aligned with the portfolio's strategy. Managing these factor exposures is essential to ensure that the portfolio remains true to its intended investment strategy.

4.????? A more comprehensive approach to position sizing involves considering absolute volatility, active risk contributions, and factor implications. This ensures that position sizes are based not only on potential returns but also on their impact on overall portfolio risk and factor exposures, leading to more robust and resilient portfolios.

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Portfolio Construction

1.????? A well-constructed portfolio is not merely a collection of individual stocks. Even if each stock is selected through rigorous analysis, the portfolio as a whole can deliver a performance pattern that is radically different from what was expected and promised to clients. This discrepancy arises because the aggregate common exposures of stocks can far outweigh their individual idiosyncratic exposures.

2.????? For example, owning one stock in Brazil can present an idiosyncratic exposure to that specific stock in Brazil. However, if you own ten stocks at equivalent position sizes in Brazil, the shared exposure to the Brazilian market becomes more significant than the individual characteristics of each company. This shift means that instead of applying a fundamental thesis to individual stocks, the portfolio effectively takes on a macro view on Brazil.

3.????? From a portfolio construction perspective, it is crucial that aggregate factor exposures are managed carefully. First, these exposures must be consistent with the investment strategy. Second, they should be entered into deliberately and not merely as a byproduct of the stock selection process. Third, they need to be properly scaled; even if the exposures are appropriate and intentional, excessively large exposures can overwhelm the idiosyncratic attributes of the stocks.

4.????? Effectively managing factor exposures is essential for long-term success. Mismanaging them can lead to unintended risks and, over time, erode alpha. Therefore, portfolio construction requires a strategic approach to ensure that the collective exposures align with the intended investment strategy and deliver the expected results to clients.

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Firms can significantly enhance their ability to deliver alpha and provide a more consistent performance pattern to clients by improving their backtesting, screening, position sizing, and factor exposure management. Relying solely on stock selection to generate alpha means deliberately ignoring many other valuable sources of alpha available to portfolio managers. By integrating these tools, firms can better manage risks, improve returns, and align their portfolios with their strategic objectives. If firms fail to consistently deliver alpha, it is likely that asset attrition will remain a challenge. Therefore, it is imperative to utilize all the tools at their disposal to achieve superior investment outcomes and retain client trust and satisfaction.

Nirbhay Kumar Yury Dubrovsky, CFA Dan diBartolomeo Peter A. Schaffer, MBA, CFA, FRM, CHP AllianceBernstein 晨星 Vijay Kasarabada Saira Malik Mike Daly Thomas Hewett Anthony Sneag Rick Ruvkun Apollo Global Management, Inc. MSCI Inc. FactSet Adetola Oyegbite Dennis M. Grady Vidya Mahadevan Ellen Yaffe Elizabeth Langel Daniel Evans FRM Patrick Roberts Ryan Duffy Ravi Arulanantham Chris Field Vanessa Wintle-Thorpe Ashish Bhutani Sebastian Lonza, CFA, CAIA Giorgia Bellocchio Carolina Herrera Robert Murphy Martina Ashley Paul DeCoster Ina Dan Annette Krassner Sébastien Page Adam Clark Isaiah Gonzalez Lilian L Quah Rea Spahiu Autumn Mahoney Paul Heller Laura Bottega Jamie Schachtel Mila Popova Mark Baumgartner Mark Rooney Krista Jacobsen, CFA Loren Katzovitz Graham Officer Pierre Bordeaux Ashok Eastman, CFA, CAIA Peter Arian Rupert Hope Yie-Hsin Hung Meredith Sahi Amy Oldenburg Paige C. Scott