Conventional wisdom suggests that when the stock market is on rocky footing, that’s when the best opportunities become available.
Stocks break free of the herd-like trading that characterizes calmer conditions and start fluctuating based on specific fundamentals. If you do your homework and make the right picks, it can be a lucrative time. And that’s certainly been true so far in 2018 as active managers have gotten off to their best start in history.
“One driver for the return of alpha in 2018 may be the fact that the market has grown ‘messier,'” Savita Subramanian, head of US equity and quant strategy at Bank of America Merrill Lynch, wrote in a client note. “Stock expertise matters during messy markets. Historically, higher idiosyncratic risk has been accompanied by stronger active returns.”
But there’s also increased downside risk associated with trading more volatile stocks. With that in mind, it’s important to note that “expertise” implies traders are making well-informed, correct decisions, which then translates to outsized returns.
And while that’s all well and good, knowing that you should be raking in big returns and actually doing it are two entirely different things.
That’s where BAML comes in. Subramanian has outlined seven ways for active managers to continue beating their benchmarks to a historic degree.
To put it in Subramanian’s words, it’s a “game plan that we think improves the odds of generating alpha over time.”
1) Pick your battles
BAML notes that not all idiosyncratic stock moves are created equal, and stresses the importance of choosing companies from the right sectors.
“The stock-picker’s paradise resides in … tech, healthcare, and consumer industries … where brand, pipeline, and innovation are likely bigger drivers than macro factors,” BAML said.
2)Focus on stocks that act like stocks
“By simply limiting the universe of stocks to companies with above average ‘idiosyncratic,’ or company-specific risk, we found that these attributes were rewarded by a much wider margin,” BAML said.
3) Take the road less traveled … especially by the sell side
“The more eyeballs on a stock, the less alpha you’re likely to harvest,” BAML said. “Another pitfall avoided by steering clear of the sell-side darlings is crowding. In three of the last five years, the most overweighted stocks by active managers have underperformed the most underweighted stocks. What do crowded stocks tend to have in common? High sell-side coverage.”
4) Add some Environmental, Social and Governance (ESG) stocks
“Adding an ESG factor to many traditional shorter-term fundamental factors enhanced returns and reduced risk in all factors we examined in our backtest,” BAML said.
5) Extend your time horizon
“With resources, trading strategies, systems and eyeballs increasingly trained on short term stock dislocations, alpha over short time horizons has become increasingly hard to come by,” BAML said. “But with the paucity of resources, investment strategies and eyeballs focused on the longer-term outlooks, the alpha opportunity over a longer time horizon has dramatically increased.”
6) Know your biases
“Our historical holdings database reveals that active funds have maintained persistent biases over time,” BAML said. “While there is some justification for these biases, they are not necessarily the right tilts to have in every market environment.”
7) Cheaters sometimes prosper
“Long-only portfolios managing against the losing benchmark tend to have an unfair edge in that they can tilt their portfolio to stocks in the winning benchmark,” BAML said. “And history suggests that this is a common practice – style funds tend to outperform during periods in which their style benchmark is the laggard, and vice versa.”
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