Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 205

Find a 'sweet spot' rather than complexity

There is a distinct trend in finance towards increasing complexity over time, including individual security structures, derivatives, the creation of new ‘asset classes’ or portfolio construction techniques that combine these in different ways.

With the pressure on headline fees and costs continuing to mount and as the desire to be seen as increasingly sophisticated or differentiated grows, there is a temptation to use more complex methods of portfolio construction in building multi-manager portfolios. It might be to incorporate ‘cheap’ factor tilts, barbell strategies of passive or semi-passive and high alpha concentrated portfolios or top 20 and ‘ex-20’ mandates. The ability to slice and dice a relatively fixed pool of assets into different constructs is ever present.

As a case study, in 2009 we undertook some analysis to determine whether the increasingly complex methods of constructing Australian equity multi-manager portfolios were, in aggregate after fees and costs, adding value. Our conclusions at that time were:

“Appointing fewer managers, to larger more diversified mandates with an after-tax focus, at a point on the cost curve where average fees are minimised, would result in better after-tax and fee returns at lower aggregate risk. Such structures are simple, require less governance and lower monitoring costs and will make it easier for internal investment teams to aggregate and monitor total portfolio risk.

Complexity is over-rated.”

Our 2009 study was based on all long-only large/broad cap active managers within the Mercer MPA Australian equity universe who had a three-year track record to either January 2000, January 2005 or January 2009. We specifically excluded long short, ethical/SRI or other overly thematic portfolios from the analysis universe (for example, income). Taking the 2009 data, there were 80 managers with a three-year track record. We note that of this 80, by February 2017, only 50 remain (in their current form).

Alpha versus risk in portfolios

While we observe that fees generally increase with the level of expected alpha (and complexity), investors should have a view as to how the reward for risk (sometimes called the ‘information ratio’) might change with increasing alpha. Given the asymmetry of payoffs between managers of assets and their clients, for these higher fees to be ‘worth it’, the information ratio needs to be increasing with the alpha expectation. This is particularly the case for strategies having fixed plus performance fee structures.

These payoffs are represented below (‘alpha’ is the excess return of a manager relative to a market index).

Source: Schroders, stylised charts for illustrative purposes only.

The general view in the industry appears to be that the first chart, and possibly the second, are what most investors expect. However, in our 2009 study we showed that, at least for Australian equity portfolios, the third chart is the reality. That is, as risk rises, there is a disproportionate fall in excess returns.

An update of the analysis and finding the sweet spot

We have now updated this work. The chart below shows, for the 96 long only managers with a three-year track record to February 2017, how their actual average alpha compares with their realised tracking error (ie variation from the index, used here as a measure of risk). While tracking error is not our preferred measure of risk (in fact it is counterintuitive), it remains common, certainly in single asset class portfolio construction. In addition, we have also included data points for the three years to January 2013.

Source: Schroders, Based on Mercer MPA data, all data is gross of fees.

Several observations are worth making:

  1. The realised level of alpha in nearly all categories and time periods has been positive. Unsurprisingly, the high alpha category has been the most volatile in terms of delivery of excess return.
  2. The ‘sweet spot’ for consistency remains strategies in the 2-5% realised tracking error range. These tend to be ‘core’ or ‘core plus’ strategies.
  3. Very high tracking error strategies appear to have done well recently, as they did in the lead up to 2005.

However, we would hasten to add additional points in reviewing the data:

  1. Survivorship bias (that is, the data is for managers who have ‘survived’ through the period, and perhaps the poor managers no longer exist) in the data is an issue. Several strategies in the 2009 data series have had their track records removed. In particular, for the high-alpha category, the survivorship bias is extreme with only eight of the 18 strategies from 2009 still ‘alive’ by February 2017.
  2. Of the 80 (long only) strategies that had a three-year track record in 2009, only 50 remained by 2017, yet 46 new strategies have commenced in that time.
  3. While this analysis looks at average levels of alpha, the most important thing for clients is real dollars of value add, not a percentage. For example, a strategy with $5 billion that has generated 1% of alpha (that is, $50 million) has performed significantly better than a strategy with $100 million of assets that has generated 10% of alpha (that is, $10 million). We note that almost all of the better performing strategies in the high-alpha category are very small in assets or closed to new business.

Constructing a portfolio

What happens when we construct different types of portfolios and allow for the costs of implementation?

In order to understand the likely post-fee impact of alternative strategy configurations, we need to make some broad assumptions about likely fee levels for different mandate types.

For the purpose of this analysis, we have made the following assumptions with respect to average fee levels. While one could ‘argue the numbers’, it is not so much the absolute levels that are important but the relativities between each type.

Source: Schroders assumptions. The ‘expected alpha’ amounts have been determined with reference to the averages from our four analysis periods. Enhanced core uses the averages from strategies with 0-2% tracking error, core is 2-4% and high alpha is >4%. We have not allowed for survivorship bias which could reduce the high-alpha numbers further. Many high-alpha strategies have performance fees which can materially skew fees higher in a multi-manager construct. For index managers, we assume a slight positive ‘alpha’.

Assuming a circa $5 billion Australian equity portfolio, the chart below shows the outcomes of different manager configuration options.

Source: Schroders. The 2, 4, 6 and 8 refer to the number of managers in the various multi-manager constructs.

There appears little benefit to more complex structures and the commensurate increase in fees and governance. By way of sensitivity, fees would have to be about 30% lower than that assumed for the high alpha category to be broadly equivalent to the core structures (assuming no cost to the increased governance and similar levels of survivability).

In 2009, former Chairman of the Federal Reserve, Paul Volker, commented on a conversation with a Nobel Prize-winning economist about the value of financial engineering to the real economy,

“Much to my surprise, he leaned over and whispered in my ear that it does nothing. I asked him what it did do and he said that it moves around the rents in the financial system and besides that it was a lot of intellectual fun.”

 

Greg Cooper is Chief Executive Officer at Schroders Australia. This article is general information that does not consider the circumstances of any individual.

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.