With the goal of generating consistent excess returns, actively managing an equity portfolio requires establishing sound methodologies and repeatable processes. We think a process based on fundamental security-level analysis can lead to superior risk-adjusted returns. Academic literature indicates bottom-up stock-selection strategies tend to generate excess returns over the entirety of the business cycle more effectively than top-down or even sector-rotation strategies. But identifying securities capable of generating returns greater than those of the broader equity universe is insufficient. Robust portfolio construction matters.

Among the numerous approaches to constructing an equity portfolio, one gaining popularity in recent years is prioritizing active share, or the degree to which a portfolio’s weightings diverge from the benchmark. How much a particular stock is overweighted or underweighted is determined by the manager’s level of conviction, which is, in turn, the result of in-depth security-oriented research. While a step in the right direction, a complement to active share is integrating the concept of Implied Alpha in portfolio construction.

Implied Alpha is best viewed as a measure of a manager’s risk-adjusted conviction in a security. It is risk-adjusted as it incorporates not only the return potential of an individual security but also how inclusion of that security impacts the volatility of returns of the aggregate portfolio. The additional level of volatility assumed when increasing active risk – or tracking error – can be considered a cost. For this cost to be justified, managers should optimize their underlying skill in security selection. The result should be the positions with the highest level of risk-adjusted conviction being among the largest contributors to the portfolio’s active risk.

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