The landscape for equity investors (whether DB pension funds, DC schemes or individuals) has changed and evolved hugely in recent years. Much of what was previously considered “alpha” can now be explained by well documented factors and systematic approaches. True alpha still exists beyond this, but equity portfolios probably need fewer managers than has been historically the case.
There is a clear trend to increased allocations to both Passive and Smart Beta, but the fact remains the majority of investors are paying for Alpha that they may or may not be getting.
So what now/next steps
Institutional investors, including pension schemes, should constantly be searching for the most efficient asset mix to generate the returns they need to meet their objectives. For some DB pension schemes, and most DC schemes or High Net Worth individuals this is likely to mean a significant allocation to high-returning liquid markets asset classes.
One component of this allocation will often be an allocation to equities (alongside other diversifying risk premia outside equities). This allocation to equities will bring equity market beta, as well as the potential for the additional smart beta, smart alpha and true alpha components described above.
What is clear is that institutional investors should revisit current equity allocations and assess them for alpha potential and the fees being paid. They may find that, because of the evolution of equity alpha, both sides of the equation could now be improved.
A Bit of History
Equity allocations for UK Pension schemes have fallen from a peak of 80% in the early 1990s to around 33% today (according to data from both UBS and the PPF).
Yet they remain the single biggest asset side risk factor for the majority of schemes.
This decline has typically funded increased fixed income and alternatives allocations as DB schemes have become more risk-aware. For schemes in the “Beginning” and “Middle” game (rather than the “End” game), who typically need to generate significant returns in excess of their liabilities to become fully funded, equities are an important return driver. This is also the case for investors in DC schemes and indeed for High Net Worth clients.
While proponents of passive investing have dominated the active vs passive debate in recent years (in the UK at least), the vast majority of equity assets are still with active managers. In the Investment Association’s latest Asset Management Survey, they found that 76% of total UK Assets under Management were in Active strategies, 20% in Passive and 3% in Smart Beta.
Alpha describes the excess returns a fund can generate relative to the return of a reference benchmark. This benchmark return is called Beta. Traditionally, for equity portfolios these benchmarks were market cap weighted indices, such as the FTSE All Share or S&P 500.
Since the mid 1970s, it has been possible to buy cheap access to them via passive funds and thus a fund manager’s returns have been judged against such alternatives.
Over time, though, what was thought of as Alpha has gradually shrunk, with Style Beta taking its place.
Fama and French’s work in the early 1990s revealed cheap stocks and small stocks outperformed large and expensive stocks. Jegadeesh and Titman (1993) and Cliff Asness (1994) then added the concept of Momentum, while the Low Volatility anomaly was being formally written about by 2006 (Clarke, De Silva and Thorley).
With each of these discoveries, part of what was thought of as Alpha became Style Beta, as fund manager excess returns were being driven, usually unwittingly, by such factors.
Since the 1980s, quantitative strategies that use underlying factors representing styles such as Value, Quality, Momentum and Low Volatility have been developed. They create entirely systematic portfolios of stocks that rebalance periodically as the inputs to the model change over time.
In recent years, more simplified systematic approaches have come to market, known as Smart Beta – here you get cheap and broad exposure to styles such as Value, Quality, Momentum and Low Volatility, or a blend of all.
To differentiate between the sophisticated quantitative managers and the Smart Beta offerings, we are referring to the former as Smart Alpha.
Whether it is Smart Beta, Smart Alpha or a high conviction, fundamental manager following a style based philosophy (what we call True Alpha), the underlying driver to generate excess returns is to exploit a behavioural bias in other market participants:
- Value exploits the tendency of market participants to over-react to controversial news or events because of the behavioural bias of Loss Aversion. A Value strategy is then able to benefit from mean reversion in the share price as the fear begins to dissipate.
- Momentum exploits the tendency of market participants to under-react to new data because of the behavioural bias of Anchoring. A Momentum manager is then able to benefit from the trend in price as perception slowly changes.
- Quality exploits the tendency of market participants to have overconfidence in their ability to forecast the future. Many investors do not expect high quality companies to sustain their strong profitability in the longer term, and consequently miss out on the long-term compounding of the reinvested cash flows.
- Low Volatility exploits an investor preference for glamour stocks, known as the Lottery Effect. They willingly accept lottery-like risk in pursuit of perceived better-than-average returns. By avoiding such stocks, a Low Volatility strategy can deliver superior risk adjusted returns.
All of the above approaches have been empirically proven to work over the long term (see Chart 1).
As humans slowly change, such biases should persist into the future, though clearly they will not work all of the time.
Active fundamental fund managers have been benefitting from such factors, sometimes deliberately, though mainly unwittingly, for years. For example, a manager with a Growth philosophy may have, on the surface, a good track record of generating what appears to be Alpha.
However, once you account for the Quality and Momentum effects (which they were not directly targeting, but are often characteristics of better “Growth” stocks), the Alpha will likely be diminished or vanish completely.
Where Are We Now?
This style based framework has existed in academia and in the quantitative fund management world for some time. Yet the bulk of the active fund management industry are still running low conviction equity products guilty of:
- unclear investment philosophies;
- providing little more chance of Alpha (or often less) than systematic options;
- charging higher fees for the privilege
The advent of Smart Beta has now provided investors with a cheap, non-passive alternative.
This new and systematic competition has encouraged Smart Alpha managers, “the quants”, to compete on fees and simplify their pitch to new investors, which in the past tended to be overly complex and off-putting.
Investors no longer need to pay active managers to hold stocks just because they are in the benchmark.
A Smart Beta or Smart Alpha strategy will provide a diversified exposure to the market, and tilt to an empirically backed factor or combination of factors – and for a much lower fee. The net of fees outcome will likely be similar (or superior) to the low conviction active offering.
Is There a Role for Active in the Future?
In this Smart Beta world, investors therefore need fewer managers than they probably have already. They can save money on fees at the same time by replacing their low conviction active managers with Smart Beta or Smart Alpha offerings.
Inevitably, this will lead to the extinction of many low tracking error, low active share strategies that are currently offered by active fund managers. Such firms will either die or be forced to evolve.
However, there is still a place for fundamental active management.
Only a human can do the deep due diligence on companies that provides a genuine and forward-looking idiosyncratic view. This depth of research creates conviction, which can then be translated into concentrated, best ideas portfolios capable of outperforming Smart Beta or Smart Alpha – a True Alpha.
For example, while a Smart Beta strategy by necessity tends to contain around 1,000 stocks, the sophistication of a Smart Alpha approach can take this down to around 200. A True Alpha manager is more likely to be running a high conviction strategy of 30 – 50 stocks, sometimes less, and this ‘best ideas’ approach can therefore outperform the more diversified offerings.
Active equity management is a zero-sum game, however.
Every buyer of a stock must have a seller on the other side, who either has a different opinion on the company or motivation for trading.
Ultimately, for every outperformer there has to be an underperformer and in the long-run the average manager will provide benchmark like returns before fees. It is not enough to simply buy any high conviction, higher active share strategy – the manager themselves needs to be of above average ability in the first place.
Thorough due diligence is still required – the best managers have a clearly articulated, empirically backed philosophy with a robust process designed to combat the pitfalls of their chosen approach. But by screening out all of the low conviction strategies, time is freed up to spend properly analyzing managers with the best chance of delivering True Alpha.
How Can Investors Improve Their Equity Allocations?
Investors now have a chance to improve and save fee-budget on their equity allocations by integrating systematic strategies and high conviction fundamental strategies together.
The advent of cheap Smart Beta offerings has begun to force quant and fundamental managers alike to be more competitive on fees, creating an ideal opportunity for investors to revisit their allocations.
One of the biggest decisions equity allocators in the UK have is whether to take a global or regional approach to constructing an overall equity portfolio.
The answer can be either or both and depends on a number of elements such as fee budget, return target and size of assets to invest. Ultimately, though, the world is a big place and a lot for a human or team of humans to cover. Humans have an edge over machine in terms of depth of research, whereas machines have an edge in terms of breadth.
A quantitative process is able to analyze and compare thousands of stocks at the same time and is therefore well suited to looking at a broad opportunity set, such as global and can be constrained by imposing a regional boundary. A fundamental fund manager is better suited to focusing on a smaller set of stocks they know better than anyone else.
There are obviously a multitude of ways to combine managers, but here are two stylized Global Equity examples. For simplicity’s sake, we will assume Smart Beta generates Benchmark +1% Alpha p.a. and costs 20bps, Smart Alpha +2% for 30bps and True Alpha +3% for 60bps.
- Style Blend
A mix of global Quality and Momentum strategies with specialist regional Value managers.
Momentum as a style is well suited to a systematic implementation. Therefore, a global approach allows the strategy to go where the momentum is, rather than be restricted by regional borders.
On the other hand…
Global also suits a Quality manager, as they can concentrate on the small subset of the highest quality stocks regardless of geography, rather than having to compromise because of regional constraints.
To create a high conviction Value portfolio, though, it can be advantageous to use fundamental regional specialists.
Value investing typically involves buying into controversial situations. Local knowledge about companies, sectors, management teams, regulation or politics can be the edge required for a fundamental value manager to generate Alpha.
A Smart Beta or Smart Alpha regional Value strategy can still be of use, however, if fee budget or manager availability rules out a True Alpha manager. That said, it would still require a reasonably broad opportunity set, such as the US or Europe.
Such a blend as illustrated above could have an overall alpha target of 2.4%, and be created for only 45bps.
Depending on fee budget and manager availability, it would be equally valid to create an all True Alpha combination as well.
- Multi-Factor Core and Satellite
A core multi-factor Smart Beta engine, with some higher alpha satellite managers.
Here the bulk of the portfolio can be an inexpensive, Smart Beta blend which can then free up fee budget to spend on a handful of higher conviction managers.
As illustrated above, such a blend could have an overall alpha target of 1.6%, and be created for just 31bps annual management fees.
Depending on fee budget and manager availability it would be equally valid to create a Multi Factor Smart Alpha core instead of the Smart Beta version. This would take the alpha target up to 2.1% and the fee to 36bps.
These are just two stylized examples and of course there are a multitude of ways of combining equity allocations.
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