The current craze for ‘high conviction’ Australian equity funds is a classic case of “fallacy of composition”, according to WestLB Mellon Asset Management’s Greg Vaughan, as institutions with more than $1 billion reduce information ratio by offering them.

Testing by the quant manager found that the ‘high conviction’ style, defined as permitting a minimum 2 per cent portfolio weighting to any one stock and a maximum 5 per cent, increased information ratio up to about $1 billion under management but eroded it thereafter. For a ‘high conviction’ $5 billion portfolio to enjoy 30 days of impact-free trading when exiting or entering a stock – that is, to be responsible for less than a quarter of trade in the stock each day – that portfolio would only be able to consider stocks in the ASX top 50. “That’s a mug’s game…you’re crimping your universe right down and offsetting the ideas that work with the illiquid alpha you can’t access,” Vaughan said. Medium-to-large institutions which introduced a ‘high conviction’ product were compounding their capacity problems in the small Australian market, he suggested. “In reality, the ideas they have for the high conviction fund are going to be similar to those for their diversified Aussie equities offering, there’s no petitioning…it’s arguable the introduction [of a high conviction fund] disadvantages the traditional clients.” High conviction funds or fund-of-funds had their place as long as FUM was kept low, Vaughan said, but added the style was “intuitive”, and that portfolios also needed representation from more “reasoned” processes, such as long/short funds with ranked positive and negative bets.

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