Investors who are paying fees for active management should understand whether they are receiving value for money.
The process of deploying capital in an active equity management programme is a familiar one for large superannuation funds. The fund chooses a diverse mix of managers and styles and provides each manager with a share of this capital to manage. The fund sets some boundaries around how far each manager can deviate from a simple set of 'benchmark' market exposures to chase market outperformance. These boundaries, measured by a concept known as 'tracking error', define what we might call an active risk budget.
The active risk portion of a portfolio
The boundaries define a budget in the sense that they give the manager a limited amount of space to play in or set a level of allowable risks in the portfolio, to generate extra returns. While there are many, varied nuances to these arrangements, the manager’s job is to use this active risk budget wisely, to maximise the manager’s chances of delivering outperformance. Each month’s performance report will include a handful of numbers which show the success (or otherwise) of the manager over short and long periods.
Simply put, if the manager's portfolio has delivered 8% and the market 6%, the manager has been successful. It is a sore point for some (perhaps unfairly) that if the manager has delivered minus 2% to the market’s minus 4%, the manager has also been successful.
Long-term investors want to better understand not only what performance was delivered, but how. It is a better way of gaining confidence that the manager is ‘true to label’, that the performance is due to skill, not luck, and that the performance is replicable over a longer term. A useful way to answer these ‘how’ questions is by looking at the way managers use their active risk budgets.
We recently offered to help two large funds (independently) understand how their equity managers were using their active risk budgets. We compared a snapshot of each manager’s portfolio holdings to a portfolio of benchmark (index) holdings and performed an attribution to identify the different sources of active risk. We explain below what sophisticated investors can do with these insights.
Things to look for in active attribution
First, such an analysis can highlight active managers who are not using much of their active risk budget. Since funds pay active management fees on the entirety of the manager's portfolio, a discovery like this should spur spirited discussions between investor and manager. Reasonable explanations could be that the manager's style is to adopt benchmark weights where the market looks overvalued across the board, or if the manager trades small positions at high volume, or if liquidity is an issue. But it could also unmask a genuine problem, like a lack of conviction or a manager banking outperformance in a prior period that they do not want to risk unwinding.
Second, an analysis of active risks can uncover managers which are similar in style. Many managers offer a tiered management fee schedule for large funds (i.e. lower fees for larger mandates), so there may be an opportunity to consolidate multiple manager mandates into a smaller number of genuinely diverse managers to reduce fees and complexity.
Third, managers who rely predominantly on sources of risk that are not idiosyncratic (that is, are defined by common, measurable attributes) are susceptible to being replaced (or to use an edgier term, disrupted) by lower-cost rules-based strategies. For example, if a manager’s active risk comes primarily from tilting into stocks with value characteristics (or yield, growth, momentum, etc.), then an investor may prefer to find a factor manager who simply builds a portfolio to track a value index, much like a passive manager. Similarly, if active risk is mostly coming from size bets that differ from the market, the fund could look for a more equal-weighted strategy that can be implemented more cost effectively in a systematic, transparent way.
Fourth, an active risk attribution can highlight 'style drift', i.e. a manager who is not using the skills and approach the fund expects. If a fund investor is paying an active manager for a 'growth at a reasonable price' style, but their active risks are mostly coming from exposures relating to size, low volatility, stocks with common leverage characteristics etc., this flags an important issue.
Fifth, putting the active risk pieces together shows what the fund investor is really getting from a 'whole-of-portfolio' perspective. Sometimes when manager holdings offset each other, the noble aim of diversification may translate to a portfolio with hardly any overall active risk – more like a very expensive index portfolio! If the objective is to build a style-neutral portfolio, the fund might be surprised to find that multiple manager 'double-ups' lead to a significant overall bet in particular countries, sectors, or style risks. Alternatively, if the fund has an overall conviction in a certain area (for example, that large-cap markets are efficient, and so small caps yield active returns), a whole-of-portfolio view of active risks can show whether the sum of the portfolio’s parts delivers the intended small-cap risk exposure.
Active risk insights empower long-term investors as they help explain what is driving a multi-manager active equity investment programme, allow manager assertions to be tested against the evidence, and enable funds to compare their portfolio objectives to the real-world portfolio of risks that has been created.
Raewyn Williams is Managing Director of Research at Parametric Australia, a US-based investment advisor. This information is intended for wholesale use only. Parametric is not a licensed tax agent or advisor in Australia and this does not represent tax advice. Additional information is available at parametricportfolio.com.au.