The Australian equity portfolio management industry is highly competitive. However, the portfolios it delivers can be under-diversified by security and sector, and key product offerings appear undifferentiated to all but the keenest observers. With the exception of some funds focussed on companies outside the largest 100 companies, most managers’ portfolios mirror the capitalisation-weighted S&P/ASX 200 index.
Is this a problem? After all, over the last two decades the returns from professionally-managed Australian share portfolios have been attractive. To the extent that there is a problem, it is fair to say a good deal of responsibility rests with clients and intermediaries rather than investment managers. In this industry products and services respond rapidly to well-articulated and consistent demand but the incentives clients set for managers is a key impediment to innovation.
Clients and their advisers define equity mandates in terms of the S&P/ASX 200 benchmark portfolio, and assess performance relative to the benchmark over short periods. Sometimes management contracts incorporate performance fees which specifically reference these benchmark returns. It is therefore entirely sensible for a manager to reflect their investment insights through a portfolio of securities whose weights are anchored to the security and sector weights of the benchmark.
The resulting portfolios become under-diversified because the benchmark itself is under-diversified. While the index incorporates around 200 securities, its eight largest names represent over half the benchmark capitalisation while two of the ten industry sectors – Financials and Materials - represent over 60% of its capitalisation. A manager who is not attracted to these particular segments of the market, but operates under a benchmark-focussed mandate, can feel constrained in terms of how aggressively they can represent these views in their portfolio. Where the manager would prefer to express a favourable view of these market segments, there is a risk that the portfolio becomes dangerously concentrated.
How might clients and intermediaries reframe mandates to better leverage managers’ investment insights? The starting point is to understand how an investor defines investment success. Is the benchmark index really so important to achieving the client’s goals? Here we consider ways to deliver superior benchmark-relative portfolios as well as identifying some increasingly important alternative goals.
Benchmark-relative approaches and expensive indexing
Super funds and large wealth managers typically conform to the institutional approach of delivering benchmark-focussed Australian equity portfolios to their members and clients. They believe, perhaps implicitly, that their own performance will be assessed relative to the benchmark index or relative to their benchmark-focussed peer group.
These portfolios are often created by allocating broad market mandates to several equity managers, each selected for their capacity to deliver returns in excess of the S&P/ASX 200 index. Given the concentrated nature of the benchmark this approach can be an inefficient and expensive way to capture and deliver the managers’ collective insight.
The source of the inefficiency is most apparent in the super funds’ overall exposure to the larger companies in the market. Rather than directly reflecting a manager’s optimism about a stock’s return prospects, the aggregate exposure to a large-cap company ends up reflecting the managers’ outlook for these stocks plus their different attitudes to benchmark-relative risk management.
In practice, super fund managers can end up trading between themselves in these larger names which is inefficient from a transaction cost, tax and management fee perspective. This is most evident in cases where a position taken by one manager largely offsets the position of another. This inefficiency leads to the somewhat unfair description of multi-manager portfolios as ‘expensive indexing’.
One simple approach to address this is to specify mandates that require managers to operate in market segments where their insights are likely to be most effective. For instance, the 20 largest companies are extensively researched by analysts yet coverage of mid-cap and small-cap names is more limited. A skilful manager who takes a position in these less researched stocks could earn a higher reward for risk.
A super fund that mandates most of its Australian equity managers to replicate the benchmark for the market’s top 20 stocks, while focussing on stock selection for the remainder of the universe, obtains several benefits:
- Transaction costs, tax leakage and management costs will be reduced in this portfolio design.
- While the level of return above benchmark may be modestly reduced, relative to the approach based on broad market benchmarks, the profile of the excess returns delivered should be far more stable.
- Super funds that are genuinely concerned about benchmark concentration in Australian shares have the opportunity to adjust their overall share portfolio without disrupting their underlying managers preferred positioning.
Some SMSFs might be more attracted to managed funds where exposure to larger Australian companies has been excluded. These SMSFs might believe they are as well-placed as the professionals to build a portfolio of large cap stocks while acknowledging they lack the capability to research smaller companies.
Goal-based strategies
There are a growing number of investors who care more about the achievement of their own specific goals rather than sweating on a manager’s short-term performance relative to a benchmark. For these investors the benchmark index merely presents an opportune set of securities rather than a neutral portfolio or a performance hurdle.
Their focus is on the design and management of a portfolio of securities with suitable fundamental and technical characteristics to support their desired outcome. When compared to benchmark-focussed approaches, these tailored portfolios typically have higher exposures to mid- and small-cap stocks and less to the large-caps.
Three differentiated investment outcomes appear to resonate with clients:
- the delivery of a sustainable income stream (Australian equity income strategies)
- resilient growth in wealth (resilient equity strategies)
- high, long-term compound growth in wealth (long-term, long only strategies).
The critical distinction between these goal-based strategies and the benchmark-focussed approach is that managers are responsible for the total risk and return characteristics of their portfolios rather than just excess return and tracking error to benchmark.
Summary
The vast majority of managed funds and mandates in Australian equities deliver broad market portfolios. The future is likely to be different with clients becoming more involved in specifying the segments in which their managers operate and the outcomes they require.
Jeff Rogers is Chief Investment Officer at ipac Securities, AMP Capital.