Insights for advisers, by advisers

What does High Conviction mean?

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Often used to describe a particular type of investment style – for example, the High Conviction Equities Fund  “conviction” is all the rage in equity markets today. This type of strategy usually holds between 2030 stocks (or any other asset, for that matter) which are considered high-quality blue-chip investments that have a strong competitive position and high market share. It’s common for a manager to say their fund is a “high-conviction” fund, that houses a small quantity of stocks that have been “hand-picked” as their best high-performance picks for the next several years. Because the number of stocks is quite small, the individual performance of each company can make a huge difference to the fund’s performance.

A good example of a high-conviction fund is the ARK Innovation exchange traded fund (ETF), which has been massively popular in 2020. This fund offers investors access to a highly concentrated portfolio of stocks that can invest in listed companies with a tilt towards “disruptive innovation.”

The flagship fund – Ark Innovation – returned nearly 150% in 2020 in the height of the pandemic. At the time of writing ARK Innovation is down 23% in just two weeks. The largest active exposures in the portfolio are consistent with the stocks that have the best rating by ARK. Portfolio construction guidelines limit the portfolio’s exposure to any one stock or sector. The result is a concentrated portfolio of between 15 to 40 stocks that the firm believes are likely to perform.

The portfolio is loaded with stocks that have skyrocketed recently, such as Tesla (NASDAQ: TLSA), Square (NYSE: SQ), Teladoc Health (NYSE: TDOC), Roku (NASDAQ: ROKU), and Shopify (NYSE: SHOP). High-conviction investing can create greater risks and does not always deliver the alpha that investors seek. Picking 20 or 30 stocks doesn’t automatically lead to a better outcome than choosing a larger spread of investments. There is a large element of risk, because all it takes is one bad stock slump to ruin a year’s performance. On the other hand, at least the managers are being truly active, and “earning their fee.”

As in the case with ARK Innovation, it’s great when the fund manager gets it right, but when it is on the wrong side of stock price moves, losses are magnified.

The qualitative characteristics required to have high conviction in a company include:

  • An easily understandable business with reasonably predictable future cash flows;
  • A business that has control over its own destiny and a buffer against uncontrollable events;
  • A business that generates more cash than is required to operate it; and
  • A business run by honest, trust worthy management that treats shareholders as partners.

Investment manager Schroders says concentrated portfolios typically hold less than 30 stocks, but concentration “cannot be viewed in isolation from the universe from which a portfolio is built.” Using the S&P/ASX200 as an example, Schroders says a fund manager might pick 30 stocks from the S&P/ASX 200, but this is actually the same level of concentration as a portfolio of 75 stocks selected from the broader S&P/ASX All Ordinaries universe of about 500 companies.  

According to Schroders, “both the 30-stock and 75-stock portfolios …… would have the same level of ‘conviction’ if the same depth of research is conducted across both sets of opportunities.  Clearly you would need a larger team of analysts to accomplish this across a larger universe of stocks.”

To Schroders, skill rather than conviction is what matters most. “It’s no use having a high conviction in your stock picks but get them spectacularly wrong. Conviction should be a measure of the skill of the investment team, and this is not measured by how many stocks you own, but by the consistency and persistence of beating the benchmark.”  

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