n today's low return and low volatility environment managers are going to have to take more risk to ...
n today's low return and low volatility environment managers are going to have to take more risk to achieve decent returns. That is the opinion of Dan Gardner, head of risk management at Martin Currie, who told delegates managers are going to have to look very hard at how and where they generate returns. He began by demonstrating just how far equity returns have fallen and just how much they have been compressed. Looking at the performance from the UK All Companies sector he pointed out that in the last five years the spread of returns between top and bottom-performing funds in the sector has narrowed considerably.
"All UK equity funds have started to behave in a similar way. More worryingly, for the past couple of years, the average fund has actually underperformed the market," he said. Gardner noted the same trend can be seen in most equity sectors, including Pan-Europe and Global equity funds.
Martin Currie believes it is no coincidence this is taking place at exactly the same time as market volatility is falling heavily. Gardner said: "The range of opportunities across all the stocks in the universe has come down. As a result, all the equity funds will behave in a similar way."
Most investors think the skill of a fund manager is the ability to convert risk into return, argued Gardner, a characteristic usually measured by the information ratio. He added: "So if you turn that round the other way, return is simply skill times risk. But risk has fallen, market volatility has fallen, so to try to achieve the same levels of return, you've got to shift the skill levels up. Fund managers have to be better at picking those stocks that outperform.
"But I would argue that skill levels of fund managers tend to stay reasonably constant. So if we can't shift the skill levels up, what do we have to do? We have to increase the risk. As buyers, if you hire a manager to give index plus 1%, 2% or 3%, you have to be sure that the manager is taking enough risk to allow them to achieve that return."
One way that this could be avoided is if volatility were to rise again but Gardner suggested the market is not pricing such a move in. "Investors have to decide: do they think market volatility is going to stay at its current rate of 10%, return to the long-term average of 20%, or something in between?" he said.
"One way of looking at a consensus for that is to go to the options market. Traded options have implied volatilities in them. If you look at them in the UK, Europe and Japan, they are pricing in a volatility hike of only about 2% or 3%. So people think this low market environment will stay for a period of time."
Among the ways managers can increase risk is by running more concentrated portfolios or taking larger bets at sector and theme level. "We have recently seen strong differential performance between value and growth," said Gardner. "Should managers therefore be taking a bigger bet on growth outperforming value? Or small cap outperforming large cap?
"The other option is to hold stocks that behave very differently from the rest of the universe; that would take you more into mid and small-cap stocks. You could also use better risk models; or use them in a more proactive way."
He stressed that if a group used a risk management system it had to be transparent to clients as to exactly what it was doing. Gardner said: "What we don't want is that in two or three years' time, for example, we have beaten the index by 0.5% and then the client says 'I wanted index plus two'. The fact is that there is no magic wand - you just have to manage your client's expectations."
Returns are falling as is the range of returns.
This is happening because volatility is coming down.
The market does not think volatility is rising any time soon.
It impossible for fund managers to suddenly become better stockpickers to compensate for lower returns.
Instead funds will need to increase their risk level - for instance, by running fewer stocks in a portfolio, taking bigger theme and sector bets, or looking at value or growth tilts or market cap bias.
It is vitally important that the client understands the risk management process and objectives of a fund group.
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