High-Conviction Active Investing: A Retirement Plan's Best Friend Or Foe?

High-conviction active investing is a strategy that involves investing in a small number of carefully selected stocks or other assets that are believed to have strong competitive positions and high market share. While this approach can create greater risks, it can also lead to higher returns. On the other hand, retirement plans typically focus on long-term, conservative strategies that aim to balance risk and return to provide stable income during an individual's retirement years. So, is high-conviction active investing appropriate for a retirement plan?

When considering the suitability of high-conviction active investing for a retirement plan, it is essential to evaluate the investor's risk tolerance, time horizon, and overall financial goals. While high-conviction strategies can offer the potential for higher returns, they also carry a higher level of risk compared to more diversified approaches. Retirement plans, on the other hand, often prioritize capital preservation and stable income over high returns.

Additionally, the costs associated with high-conviction active investing strategies, such as management fees, need to be considered. Retirement plans, especially those with limited funds, may find lower-cost passive investing strategies more suitable.

In conclusion, while high-conviction active investing can offer the potential for higher returns, it may not be the most appropriate strategy for a retirement plan. Retirement investors typically seek to balance risk and return, prioritizing capital preservation and stable income. However, high-conviction strategies can be considered as part of a diversified retirement portfolio, especially if the investor has a longer time horizon and a higher risk tolerance.

High-conviction strategies vs passive investing

High-conviction strategies and passive investing are two contrasting approaches to investment. Passive investing is a long-term strategy that seeks to build wealth gradually by minimising buying and selling. It is a low-cost, low-maintenance approach that aims to match market performance by constructing well-diversified portfolios. On the other hand, high-conviction strategies are a type of active investing, which involves more frequent buying and selling to try to outperform the market.

High-Conviction Strategies

High-conviction strategies are a form of active investing, where fund managers take a bold approach to try to beat the market. These strategies typically hold a small number of carefully selected stocks, usually between 20 and 30, which are considered high-quality, blue-chip investments with strong competitive positions and high market share. The performance of each company has a significant impact on the overall fund's performance. High-conviction funds are often marketed as hand-picked and are expected to deliver high returns over several years. Examples of high-conviction funds include ARK Innovation, Chester, Ophir, and Magellan.

Passive Investing

Passive investing, on the other hand, is a long-term strategy that seeks to minimise costs and complexity. It is often achieved through index investing, where investors replicate and hold a broad market index, such as the S&P 500. The goal is not to outperform the market but to match its performance over time. Passive investing aims to build wealth gradually by reducing fees and operating expenses associated with frequent trading. It is a buy-and-hold strategy, where investors purchase securities with the intention of holding them for the long term.

Comparing the Two Strategies

High-conviction strategies and passive investing represent two different philosophies towards investing. Passive investing is often favoured due to its lower costs, simplicity, and tax efficiency. It provides diversification and avoids the emotional decision-making that can come with active investing. However, it is subject to total market risk, and passive funds rarely beat the market.

In contrast, high-conviction strategies offer the potential for higher returns and the ability to react to market changes. Active managers have the flexibility to hedge their bets, exit specific stocks, and tailor tax management strategies. However, active investing is generally more expensive due to higher transaction costs and analyst fees. It also carries greater risk, as the performance of a high-conviction fund is heavily influenced by the individual companies within the fund.

Retirement Planning

When considering retirement planning, both strategies can play a role. Passive investing can be a good option for hands-off investors who want to see returns with less risk over a longer period. Retirement accounts, with their long time horizons, can accommodate more aggressive investment strategies, including active trading. However, it is important to consider the overall risk tolerance and goals when deciding between high-conviction and passive investing strategies for retirement.

Risk and return characteristics

High-conviction investing is a strategy that holds between 20 and 50 stocks or other assets that are considered high-quality blue-chip investments with strong competitive positions and high market share. The performance of each company has a significant impact on the fund's overall performance due to the small number of stocks involved. This strategy is often regarded as a "high conviction" fund, with a small number of stocks that have been "hand-picked" for their potential to perform well over the next several years.

The risk and return characteristics of high-conviction active investing can be analysed through various metrics. One key metric is the tracking error, which measures the difference between the strategy's performance and its benchmark. High-conviction strategies aim for a tracking error in the top 20% more than 50% of the time. Another metric is beta, which gauges the volatility of a strategy relative to the market or a benchmark, with high-conviction strategies targeting the top and bottom 10% more than 50% of the time. R-squared is also used to assess a strategy's movements relative to a benchmark index, with high-conviction strategies aiming for a lower R-squared in the bottom 25% more than 50% of the time.

The upside/downside capture metric evaluates the performance of a strategy against a benchmark during positive and negative periods. High-conviction strategies aim for a ratio above 100%, indicating performance in line with the benchmark. Additionally, the active share measures the percentage of stock holdings in a manager's portfolio that differs from the benchmark index, with high-conviction strategies featuring a high active share.

High-conviction strategies have shown the potential to deliver higher returns and lower risk (standard deviation) compared to other investment strategies. However, it is important to note that high-conviction investing can also create greater risks, and there is no guarantee that it will always deliver the desired results. The performance of a high-conviction fund is heavily influenced by the individual performance of each company in the portfolio, and a single stock slump can significantly impact the overall returns.

Long-term investment perspective

High-conviction active investing can be a viable strategy for those with a long-term investment perspective. This strategy involves investing in a small number of carefully selected stocks, typically between 20 and 30, that are expected to deliver high performance over several years. While this approach carries greater risk due to the potential impact of a single stock's performance on the overall fund, it can also lead to higher returns.

The success of high-conviction strategies depends on the skill and active involvement of fund managers. These managers hand-pick a concentrated portfolio of high-quality, blue-chip investments with strong competitive positions and high market share. The ARK Innovation exchange-traded fund (ETF), for example, provided investors with access to a highly concentrated portfolio of stocks focused on "disruptive innovation" during the pandemic in 2020, resulting in returns of nearly 150%.

For investors with a long-term horizon, high-conviction strategies can offer benefits. BMO Global Asset Management's analysis found that high-conviction strategies outperformed other subsets, delivering higher returns and lower risk. Additionally, high-conviction strategies can be advantageous in retirement accounts due to their aggressive nature and the ability to actively trade without capital gains tax consequences.

However, it is important to remember that high-conviction investing does not always guarantee better outcomes. A single underperforming stock can significantly impact the overall performance, as seen in the case of ARK Innovation's losses when stock price moves went in the wrong direction. Therefore, investors considering high-conviction strategies should be comfortable with short-term performance variations and have a long-term perspective to allow for potential recovery from any slumps.

Asset allocation

When it comes to asset allocation for retirement, the general rule is that you should shift towards more conservative investments once you retire since you no longer have an active income to replace losses. However, as you will need this money for decades, you shouldn't completely abandon growth-oriented positions. The exact balance will depend on your personal spending needs.

• Set your goals and adjust over time: Consider your life expectancy and lifestyle. If you retire at 65, plan for at least 30 years' worth of money, taking inflation into account. Your needs will change as your retirement progresses, so your asset allocation should be adjusted accordingly.
• Allocate assets to manage your risk: As a rule of thumb, be more aggressive with your investments when you are younger, as you have more time to replace any losses. As you age, shift towards more conservative assets, such as bonds and certificates of deposit (CDs).
• Plan for growth based on your spending needs: Consider how much income you will need to replace in retirement, and how close your current portfolio gets you to that number. While you don't want to take on unnecessary risk, your portfolio will need an element of growth to avoid languishing for 20-30 years in low-growth CDs.
• Age 65-70: 40%-50% in lower-risk assets, 50%-60% in higher-growth assets.
• Age 70-75: 50%-60% in lower-risk assets, 40%-50% in higher-growth assets, with fewer individual stocks.
• Age 75+: 60%-70% in lower-risk assets, with an emphasis on cash-like products, and 30%-40% in higher-growth assets, with as few individual stocks as possible.

It is recommended that you consult a financial advisor to help you create a financial plan that is tailored to your retirement needs and goals.

Active vs passive investing

Active investing and passive investing are two opposing strategies for investors to consider. Active investing is a hands-on approach that involves buying and selling investments based on their short-term performance, with the aim of beating the market average. Passive investing, on the other hand, is a long-term strategy that focuses on minimising buying and selling to reduce costs and maximise returns over time. Both strategies have their pros and cons, and many investors choose to blend the two approaches to benefit from their respective strengths.

Active investing requires a portfolio manager or active participant to make regular investment decisions. This strategy aims to take advantage of short-term price fluctuations and involves a deeper analysis of investments to determine when to buy or sell. Active investing offers flexibility, the ability to hedge bets, and the potential for bigger returns. However, it also comes with higher fees, active risk, and a poor historical track record compared to passive investing.

Passive investing, on the other hand, is a buy-and-hold strategy where investors limit the amount of buying and selling within their portfolios. This approach aims to replicate market performance by purchasing a representative benchmark, such as the S&P 500 index, and holding it for a long time. Passive investing is less expensive, simpler, and often produces superior after-tax results over the medium to long term. However, it is subject to total market risk and lacks the flexibility of active investing.

When considering high-conviction active investing for a retirement plan, it is important to weigh the benefits and drawbacks of both active and passive investing. High-conviction strategies can offer higher returns and lower risk for investors with a long-term perspective. However, they also come with higher fees and the potential for greater losses if a single stock performs poorly.

Ultimately, the decision to choose active or passive investing, or a blend of both, depends on an investor's goals, risk tolerance, and time horizon. Retirement accounts, with their long time horizons, can accommodate more aggressive investment strategies, while taxable brokerage accounts should be more conservative to reduce volatility.

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