Investors use many different strategies for picking equities, some of them well-known and widely utilized and some proprietary and based on years of personal research and strategy development. This week, we asked Reiman School of Finance Professor and AthenaInvest Co-Founder C. Thomas Howard, PhD to discuss the proprietary investing strategy that AthenaInvest employs for in their two Covestor models, Athena US Equity and Athena International Equity.
Covestor Live: In both of your models with Covestor you use a patented Strategy Based Investing methodology. On your website you explain that the process starts by grouping fund managers into peer groups and ranking them and their investments. Can you give us an idea of the criteria you are ranking?
Tom Howard: Specifically, we rank managers based on Strategy Consistency and Conviction – we don’t rank on traditional metrics such as returns, typical stock characteristics or momentum.
Through an extensive research process we identified 40 different elements or areas active equity managers focus on in the evaluation of investments; items such as management quality, price ratio, sustainable growth, quantitative modeling, etc.
As one would expect, certain elements are grouped together within strategies. For example, Valuation managers might look at intrinsic valuation, cash flow and PE ratios while Competitive Position mangers might look at management quality, innovation, fundamentals and defensible market position.
We systematically review the stated investment process of all US and International active equity managers and map keywords in their statements to the 40 elements in our system. This enables us to construct a strategy identification profile for each manager, based on the specific elements they consider. All managers are then grouped into strategy clusters based on the combination of elements they consider and our statistical cluster analysis.
CL: What data do you use to determine a manager’s conviction? Also, do you evaluate the credibility of their reasons for the conviction?
TH: Once managers have been strategy identified we append holdings data. This allows us to measure a few critical performance drivers.
- Strategy Consistency – Are managers investing in stocks with the elements they focus on? This is measured primarily by comparing their holdings with the holdings of similar managers and the market at large.
- Manager Conviction – Are managers investing with high conviction? This is measured primarily by the weight of their investments relative to their portfolio, other managers and the market at large.
- Alpha Stock Percentage – In selecting stocks we take the process a step further and look at stocks held by top managers to determine if they are held in the portfolio for generating returns or for other purposes, alpha stocks are identified as those held in the top 40 positions of a given manager.
The result is a set of measurements that are leading indicators of future performance. In essence a manager’s decisions and confidence today is more predictive than what they did years ago. It is important to note that this process is not driven by past performance or price momentum. It is a systematic approach to capturing manager skill and credibility.
In summary – We measure conviction through proprietary measures that contribute towards a manager’s overall rating. We can detect the level of conviction any particular manager exhibits and there is a strong relationship between managers that have high conviction and future performance.
CL: What interesting trends or anomalies have you found when breaking managers out into peer groups?
TH: There are some interesting trends when you take this approach to investing.
Strategy Matters – There are multiple ways to make money in the marketplace – each based on a unique combination of elements and strategies. There are an optimal number of elements – one is not enough and twenty is too many. Certain strategies such as valuation and future growth have better long term performance results.
Peer Groups Matter – Strategy peer groups are more correlated within groups and less correlated across groups – when grouping is done with the style box the reverse is true – as a result the strategy approach builds more meaningful peer groups. It is important to benchmark against strategy peer groups. Broad benchmarks can be misleading and make it difficult to distinguish between good or poor performance due to markets, strategy and execution.
Execution Matters – Managers must be active, constantly researching and evaluating ideas. Managers need an ability to rank and invest in their best ideas with confidence. There are enormous structural challenges to managing a good portfolio – size, liquidity, distribution pressures, analyst opinions, asset flows, etc – which can introduce biases to an otherwise fundamentally sound strategy.
US & International Markets are Different – Strategies perform differently in the US and International markets. We have different long term weightings by strategy for US and International markets.
Structure Matters – Smaller, focused, solo managed funds managers with high conviction tend to perform better. Larger “closet indexing managers” with excessive holdings can easily be identified and avoided.
CL: Have you found any correlations between a manager’s convictions and his or her investing strategy or success?
TH: Our research published in Advisor Perspectives clearly demonstrates that manager consistency and conviction results in better performance. “Thus DR5 (high conviction/consistency) funds during this time period (3/97-6/09) generated an average annual excess return of greater than 4% and had an 82% chance of beating the market”
Our stock research shows that stock selection using this approach is even more powerful as highlighted in our quarterly stock and funds diamond ratings performance summary.
All this leads to one unmistakable conclusion. Current behavior is more predictive than past performance and portfolios managed with this approach deliver higher excess returns.
