Industry view: The art of being unpopular

These semi-passive strategies have systematised many of the sources of outperformance formally attributed to fund manager skill.

Such funds undoubtedly pose a challenge to active management, but accessing superior returns is more difficult than simply purchasing a strategic beta fund.

Many of the strategies being exploited by these funds require a great deal of discipline to consistently implement: a responsibility that falls to the fund holder.

The paper ‘Dimensions of Popularity’, published in The Journal of Portfolio Management and co-authored by my colleague Tom Idzorek, head of investment methodology and economic research at Morningstar, and Roger Ibbotson, professor in the practice emeritus of finance at Yale, discussed this part of the fund world.

It showed many of the ‘risk premiums’ identified by academics in the past 30 years can be gathered under a simple heading of ‘unpopularity’.

While strategic beta funds (and active fund managers) often try to exploit the superior return-generating characteristics of ‘unpopular’ investments (low beta, smaller companies, value stocks etc), the key driver of outperformance is the ability of an investor to buy and then own unpopular stocks for the ‘right’ amount of time.

Few investors are able to do this consistently, preferring to herd together in popular stocks. As a consequence, investors tend to miss the outperformance potential of unpopular stocks and overpay for the popular ones.

While some are prepared to consistently buy unpopular stocks, few have the discipline to own these stocks long enough for them to bear fruit. Unpopular stocks and assets can underperform for years before delivering superior returns. While the eventual outperformance typically outweighs the prior underperformance (presenting the ‘risk premium’), there are few professional investors who are permitted to underperform for such a period and yet retain their jobs.

The success of a long-term contrarian approach is demonstrated by professor of finance Martijn Cremers. His research shows high active share alone is not a reliable predictor of returns. It is the combination of high active share and low turnover that is predictive of superior returns.

When seeking a portfolio manager, it seems it pays to look for patient contrarians who are secure in their jobs.

We might conclude that while the emergence of strategic beta strategies poses a challenge for active managers, it is unlikely to improve returns for the end investor, as the key obstacle preventing investors from accessing sources of excess returns is not a lack of skilful fund managers, but a lack of patience on the part of the investor. Only by assigning long-term mandates and removing the career risk from talented managers can we hope to generate superior returns for our investors.

Dan Kemp is co-head of investment consulting and portfolio management, EMEA investment management group at Morningstar