Bad Ideas: Why Active Equity Funds Invest in Them and Five Ways to Avoid Them

How many attractive stock ideas does Naomi, an institutional active equity fund manager, have at any one time?

“Oh, I think between 10 and 20,” she told me.

So, why did her fund hold so many more times that number of stocks?

“To round out the portfolio,” she said.

I have asked these same questions of many active equity managers and received similar responses each time. The implication, of course, is that these managers are drowning the superior performance potential of their best ideas in a sea of bad ones.

Why would they hobble their returns in this way? After all, no expert chef would serve up their signature dish with generic supermarket bread. So, why do skilled stock pickers make such errors when constructing portfolios and what can we do about it?

Are Professional Managers Skilled Stock Pickers?

The general consensus is no; they are not. On average, active equity funds fail to meet their benchmarks, which suggests that investors should avoid them in favor of low-cost index funds.

But what if managers like Naomi stuck to their 10 to 20 preferred stocks? Would their portfolios do better? Studies confirm that they would. In the most compelling of these, “Best Ideas,” Miguel Anton, Randolph B. Cohen, and Christopher Polk find that the top 10 stocks held by active equity mutual funds, as measured by portfolio weights relative to index weights, significantly exceed their benchmarks. As the relative weights decline, however, performance fades and at some point, probably around the 20th stock, falls below the benchmark.

So, professional managers are superior stock pickers — if they stick with their 10 to 20 best ideas. But most mutual fund portfolios hold many more bad idea than best idea stocks.

Collective Stock-Picking Skill

Applying a variation of the “Best Ideas” relative weight methodology, my firm, AthenaInvest, rates stocks by the fraction held by the best active equity funds. We define the best funds as those that pursue a narrowly defined strategy and take high-conviction positions and update our objective fund and stock ratings based on monthly data. The best and worst idea stocks are, respectively, those most and least held by the best US active equity funds. We derive each stock’s rating from the collective stock-picking skill of active equity funds with distinct strategies.

The following chart presents the annual net returns of best and bad idea stocks from 2013 to 2022 as distilled from more than 400,000 stock month observations. The two best ideas category stocks eclipse their benchmarks by 200 and 59 basis points (bps), respectively, as measured by the average stock return net of the equally weighted S&P 500. The bad idea stocks, by contrast, underperform. (These results would have been even more dramatic had we excluded large-cap stocks since stock-picking skill decreases as market cap increases: The smallest market-cap quintile best idea returns far outpace those of the large-cap top quintile best ideas.)

Best Idea and Bad Idea Stocks Annual Net Returns, 2013 to 2022

Performance declines as the best funds hold less and less of a stock. Those stocks held by fewer than five best idea funds — the rightmost category — return –646 bps.

The designations reflect AthenaInvest’s roughly normal distribution rating system. The two best idea categories comprise 24% of the market value held by funds, while the bad ideas account for 76% and so outnumber good ones by more than 3 to 1.

The market-value-weighted average annual return of all stocks held by funds is –53 bps before fees. Yet had the funds invested only in best ideas, they would have exceeded their benchmark. By diversifying beyond their best ideas, stock pickers sacrificed performance to build bad idea funds and became, in effect, closet indexers.

Investing in Bad Ideas

Again, why would they do this? Reducing portfolio volatility could be one motivation. But that only goes so far. On average, a 10-stock portfolio has a 20% standard deviation, less than half a one-stock portfolio’s 45% volatility. Adding stocks within this range makes sense. But beyond it, not so much: A 20-stock portfolio yields only an 18% standard deviation, and so on. After a certain point, adding bad ideas only drags down returns without contributing much in the way of diversification.

But if diversification cannot explain investing in bad ideas, what can? Emotional triggers are a key driver. Despite the evidence, many see holding a 10 to 20 stock portfolio as “risky.” But if stocks sit in a portfolio’s long-term growth bucket, then short-term volatility is not a true risk. In fact, holding only best ideas may be less risky since they should lead to greater long horizon wealth. Small portfolio skittishness is therefore an emotional reaction motivated by a desire to reduce risk rather than create wealth.

Tracking error is another emotional trigger. With its small, unique set of stocks, a best idea portfolio will have periods of both under- and overperformance. Since investors often suffer from myopic loss aversion, they are prone to overreacting to short-term losses. To alleviate their sense of disappointment, they may sell low and buy high, trading an underperforming fund for an overperforming one. To minimize this business risk, funds may overdiversify to ensure their performance tracks their benchmark even at the expense of long-term returns.

Since funds charge fees based on their assets under management (AUM) rather than performance, they are incentivized to grow ever larger and become closet indexers. In “Mutual Fund Flows and Performance in Rational Markets,” Jonathan B. Berk and Richard C. Green describe the economic rationale for such return-sabotaging behavior.

Investment consultants and platform gatekeepers further reinforce these trends. They both apply standard deviation, tracking error, and the Sharpe ratio, among other tools of modern portfolio theory (MPT), to determine whether to include certain funds in a portfolio. Based on short-term volatility, each of these measures may encourage myopic loss aversion in investors. Instead of mitigating such performance-destroying behavior, they exacerbate it.

This is especially true for the Sharpe ratio, which double discounts for short-term volatility. It reduces the compound return in the numerator while dividing by the standard deviation in the denominator. The clear signal is that when it comes to active equity mutual funds, no good idea funds need apply.

Avoiding Bad Ideas

The solution ought to be simple: We should invest in active equity funds that confine their holdings to only the best ideas. But for the reasons we outline, doing so isn’t always easy.

Those who are unwilling or unable to invest in best idea funds should opt for low-cost index funds. Those who are interested in high-performing active equity funds and are not deterred by higher short-term volatility and tracking error should look for the following:

1. Narrow Strategy Funds

Invest in specialist not generalist funds. They’ll be doing something different and have expertise in their field.

2. Narrow Strategy Funds with Long Track Records

To be sure, this does not imply that returns will be consistent, only that the strategy will be.

3. Best Idea Funds with Different Strategies

Since performance ebbs and flows, investing in four or five best idea funds with distinct strategies can smooth out the ride.

4. High-Conviction Funds with Fewer Stocks and Lower AUM

Think funds with fewer than 30 stocks and less than $1 billion in AUM. According to our active equity fund analysis, less than 15% of high consistency, high conviction funds exceed this AUM threshold.

5. Funds with an R-Squared Range of 0.60 to 0.80

As an alternative, measure fund conviction by comparing each fund’s R-squared with its benchmark. Lean toward those with scores that fall in this range.

Turning the Tide on Closet Indexing

Most active equity funds do not underperform for lack of stock-picking skill. Rather, the investment industry incentivizes them to indulge their clients’ most unproductive emotional triggers and manage business risk at the expense of long-term portfolio performance.

We all need to do our part to change this dynamic and reverse the trend toward closet indexing. So whatever you do, don’t invest in bad idea funds.

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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.

Image credit: ©Getty Images / Steven White

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