the move away from benchmark-based investing provides opportunities for fund managers but the skill requirements are much higher
The fund management industry is in the throes of yet another turn in its turbulent history. The demands of investors and the numbers by which success is measured are changing as the world tries to adapt to today's low-return environment.
But these revolutions are not new. In the 1970s and 1980s, institutional clients would allocate substantial assets to investment managers and more or less give them complete freedom to invest. The primary problem for the client was inflation; that was the benchmark managers had to beat, and there were no generally accepted measures by which the underlying risk of the portfolio could be judged.
Then came the bull market - almost 15 years of unprecedented and unrepeatable equity returns, reflecting a one-off reduction in volatility throughout the Western economies as the consensus on monetary policy matured and standards of corporate governance and transparency improved.
Understandably, managers of balanced portfolios were generally underweight equities and lagged the markets. The money moved towards more specialised mandates, and active funds, their success measured by information ratios, held sway.
As is the way of markets, the predominance of high-beta equity portfolios peaked in 2001 as equity markets around the world collapsed. Alpha was the watchword and hedge funds the vehicle of choice, with their associated measures of Sharpe and Sortino ratios.
Now it is changing once more. Hedge funds have not proved the hoped-for cure-all for two main reasons: firstly, so much money has flooded into the most popular hedge strategies that the markets are squeezing out the inefficiencies that made them so attractive in the past; and, secondly, that same wall of money has attracted a host of mediocre managers.
Finding the right manager can be as difficult as making the correct market timing decisions on traditional asset classes, and hedge fund managers have found themselves losing their reputation as magicians.
In any case, the memories of the TMT bubble are fading fast, especially after the recovery in 2004, and investors do not want to miss out on any possible easy gains there.
So what will happen next? Miles Geldard, chief investment officer of JP Morgan Fleming's global multi-asset group, believes he has the answer.
"Going forward, we will have a total return approach," he says. "Investors have an asymmetric approach to risk. That is, they are more upset when they lose money then they are happy when they make it. In a low nominal return environment, alpha is obviously more important than beta. Investors are less focused on benchmarks, and with good reason.
"The reality now is cash plus, which is very challenging. Cash is a very attractive asset class at the moment because monetary policy is tightening. Risk is defined now in terms of capital loss not relative loss. We have to get more upside capture and less downside capture, which is very difficult."
In the retail market, things are even more problematic, as the limitations imposed by concerned regulators effectively force managers into tracking benchmarks. So retail investors who want cash-benchmarked products might find themselves out of luck.
Nicola Horlick, CEO of recently-created Bramdean Asset Management, outlines the problems. She says: "With retail structures, there is no going to large cash weightings in underperforming markets. And attempting to promise downside protection as well as keeping up with a stock index is not a realistic aim. It is not possible to outperform cash, outperform the risk free rate and also outperform the index. You cannot have more than one benchmark."
A route out
Yet there are possible ways of untying this Gordian knot. One way is to give the manager full control of asset allocation. Another is to choose an asset class that can provide a manager with a route out in down markets.
Alex Pritchard, who manages both long-only and long/short small and mid-cap European portfolios for JO Hambro Investment Management, thinks it is not essential to be able to go to 100% cash to run a long-only absolute return portfolio.
"There are always unusual circumstances - special situations and defensive stocks that you can hold even in tough times," she says. "If you are imaginative you should be able to find something to invest in."
There are even individual stocks that have a consistently negative beta, which, according to Pritchard, can offer a place to hide. Having said that, she has the luxury of running a small-cap fund, and small caps can be protected somewhat from the big economic movements that hamper their larger peers through having more focused business structures and, for the domestically oriented, less reliance on macro factors, such as currency movements.
The primary cause of such useful attributes as negative beta stems from market sentiment rather than stock fundamentals, which brings us back to a core problem when it comes to large-cap managers trying to run absolute return portfolios: their performance is heavily influenced by their peers and other investors - and this can scupper the most skilfully constructed bottom-up portfolio.
Kim Asgar Olsen, head of investments for Nordea Investment funds, goes one step further. "No matter how you construe it, the underlying risk must be somewhere out there in the real world and not in the stock market. However, I think the independent source of risk in the stock market actually may well be coming from the fact that we use risk management techniques that create lemmings out of fund managers."
Active managers vs enhanced index
The result of this can be seen when one looks at the whole universe of fund managers. Goldman Sachs recently conducted research into a 1,000-strong universe of US equity funds and the results were surprising. They showed that the average active equity manager from 1989 to 2003 returned 56 bps per annum above their index. The average enhanced index manager returned 53 bps. Taking into consideration the difference in tracking errors (657 bps and 192 respectively), that gives information ratios of 0.07 vs 0.28, so enhanced investors win hands down. 'Ah', you might say, 'but what if I am good at choosing managers?'. Sadly, the story is the same, with top quartile active managers achieving an IR of 0.30 compared to their enhanced colleagues' 0.53. This makes active managers on average a worse investment decision on a risk/return basis.
But maybe that is the point - the new model investor does not judge the success of his investments by traditional standards such as information ratios. And it must be pointed out that the Goldman Sachs research is unashamedly old-school in that sense.
For example, the researchers divided funds into three categories (the previous two mentioned plus 'passive') according to their tracking errors. They did not include any funds that had tracking errors between 300 and 500 because it was 'not clear' to them what strategy they were therefore following. The optimisation programme that GSAM ran assumed that investors wanted an efficient frontier based on tracking error versus return - exactly what Geldard and Pritchard are arguing against.
protecting the downside
Kurt Winkelmann, co-head of investment strategies at GSAM, had this conclusion: "We all know that manager selection is an important part of the business but it turns out that for active managers it is absolutely critical. If you want to minimise your regret then you are pushed towards the enhanced index managers." And surely 'minimising regret' - in other words protecting the downside - is exactly what an absolute return investor wants?
Apples and pears?
Well yes, but what Winkelmann is suggesting a route to, is downside protection against an index, not against absolute capital losses. For our new model investor, the expectations have to be different and that requires a rethinking of what the point of investing is and, crucially, how the success of failure of an investment can be monitored. Back to Pritchard:
"As an investor you can hide in a relative world - it is quite forgiving," she says. "The absolute world is completely unforgiving. Either you are a good investor or you are not and if you are not it is pretty obvious.In the absolute world, I do not think it is forgivable to have a bad year or two years. In the relative world, the amount you might underperform is going to be lower, because the spread from the market is lower, which means you can get away with poor performance for longer. For an absolute investor, you can have a bad month or two months but then you have to re-appraise your position. The good thing is that you can do this because you have more flexibility."
And that is the point - absolute return managers not only need the freedom to exercise all their investment skill and imagination, they also need to have those skills to exercise. Giving an absolute return vehicle to a bad manager is like giving a Ferrari to a teenager - only do it if you don't like Ferraris or you don't like the teenager.
If you do find a good driver, however, the benefits can be considerable, not only for the investor, but also the for the fund manager.
"When you stop worrying about whether you should be over or underweight 10bps in one of the biggest index stocks you release yourself from so many ties that hold your performance down - you get to rove." says Pritchard.
"You don't worry about the next quarterly announcement from Philips or Siemens and instead you think 'I've found a great company that is doubling its sales this year.' You are not thinking like 99% of other investors out there. If you are in the realm of the 1% of investors thinking in an absolute way, you have got a much better chance of generating alpha."
Which leads us to a further challenge: what happens when the 1% of investors becomes 2%, or 5% or 50%? If Olsen is right about the influence of mainstream managers on market sentiment is right, then any successful absolute return strategy will itself be quickly subject to margin pressure and the manager will be forced to look elsewhere to find those elusive returns. Alpha doesn't stand still - it must be chased. What Winkelmann said about his universe of active managers is doubly true of absolute return managers - only the best will satisfy investors.
The final question then remains whether the effort of finding and monitoring these managers - and of changing your investment philosophy - is worth the benefits of being at the forefront the next investment revolution.
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