Using Buy-Side Analytics to Improve Stock Selections
November 16, 2010
by C. Thomas Howard, PhD
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
When managing a stock portfolio, investors and advisors must first decide on the information and data they will use to select stocks. Then, applying a variety of analytical models to this information, specific buy and sell decisions are made. Over time, investors devote considerable time and effort to refining and improving the stock-picking strategy.
Frequently, sell-side stock reports are included in the information set. Investors recognize the unique skills and company access of the analysts who author these reports and the major impact their recommendations have on future stock price movements. Sell-side reports have the additional advantage of being readily available and are distributed to a wide audience.
There is, however, a group of analysts and portfolio managers who affect future stock price movements even more: the buy-side active equity managers who “put their money where their mouth is” by ranking and weighting their best stock ideas within their portfolios. A growing number of academic articles confirm that these best ideas generate superior returns. For example, Randy Cohen, et al., in.Best Ideas, show that the top relative stock pick of the typical active US equity manager generates average risk-adjusted alpha of nearly 6% annually. In another recent study, Russ Wermers et al. in The Investment Value of Mutual Fund Portfolio Disclosure, show that building a portfolio based on mutual fund holdings, weighted by past fund performance, generates an average risk-adjusted alpha exceeding 7% annually.
Thus buy-side analytics, the process of extracting these “buy-side stock recommendations” from active equity fund holdings, can provide valuable information when selecting stocks. AthenaInvest has built a buy-side analytics platform that each month assigns a Stock Diamond Rating (SDR) to each stock held by active US equity mutual funds. The system takes into account manager quality (as measured by strategy consistency), manager conviction (as measured by portfolio concentration) and whether a stock is held for alpha generation (as measured by its relative position in the portfolio). Based on objective measurement of manager behavior and relative portfolio holdings across all active US equity funds, a Stock Diamond Rating emerges. A rating of SDR5 is assigned to the top stocks of the top managers, SDR4 to the next group, and so forth.
Past performance is not included in SDR determination, as current manager behavior is superior to past performance in predicting manager quality and performance. (See Improving on Morningstar's Ratings: Moving Beyond Past Performance in June 22, 2010 Advisor Perspectives for more details.)