Life beyond alpha and beta products

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By Roland Rousseau

Why the asset management industry needs to evolve

Roland RousseauLike all industries, asset management needs to evolve. Over 100 years, our modus operandi has remained unchanged. We still rely entirely on human talent to pick undervalued stocks who struggle to consistently beat benchmarks. The alternative, passive investing, is probably also not a viable, long-term business model given the volume of assets under management required to become profitable.

 

 

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So, how does a CEO trying to grow assets under management position his or her business when traditional active management margins are under pressure combined with declining growth? Similarly, although passive strategies remain on a J-curve growth trajectory, margins are wafer-thin, with few barriers to entry?

Most CEO’s continue to defend their traditional active business models believing that, like Kodak did when it refused to accept the growth in digital photography, investors won’t settle for mediocre, low-quality index funds when the alternative is to invest with an active manager who continuously tries to beat the market. As global flows show, the growth of index strategies is proving this logic to be deeply flawed. But, although passive management is growing, it’s a tough business to break-even and has hidden risks for investors.

Some of the larger asset management houses in SA have chosen the ‘safe’ route of promoting both traditional active funds (alpha strategies) and passive funds (beta strategies). The problem with ‘specialising’ in both active and passive products is that the sales proposition to clients is very tricky as one is selling seriously conflicted investment philosophies.

We believe that we’re on the brink of major restructuring in the SA investment industry as neither actively managed funds (skill-based or alpha products) nor passively managed funds (beta products) are sufficient to meet client needs and deliver stable growth at acceptable margins.

In our view, the industry is being revolutionised by three dimensions of transformation. Understanding these forces will show that there is an exciting, but very different, life beyond actively and passively managed investment products.

The three dimensions of transformation

We have identified three irrevocable ‘axes of change’ in the asset management industry (see diagram). Given the need for brevity, we’ll present only the concepts – and not the detail – here.

1: Active return management to be replaced by active risk management

The definition of investment skill – to deliver a higher return than a benchmark – has failed us because a portfolio return greater than a benchmark return has never been defined as ‘skill’.

According to CFA and the financial literature, the only correct definition of ‘skill’ is whether we have outperformed the aggregate risks we have taken. For example, if you manage a balanced fund, with 75% invested in equities, you will, at some point, outperform more than 90% of your peers and will also outperform CPI+5% and any other benchmark with less than 75% in equities. However, your higher return might look like skill when it is just higher equity risk. Even a passive allocation of 75% to equities over 3-5 years will beat all actively managed balanced funds that hold less than this amount in common stocks.

Similarly, many money market funds in South Africa are erroneously benchmarked against a low-risk cash benchmark (e.g. STEFI) when they hold higher yielding, riskier corporate debt instruments. Any portfolio holding instruments that pay a higher yield than cash will outperform cash over time. This kind of practice should be strongly discouraged and may even lead to intervention from the regulator.

As a result, many unit trust factsheets don’t provide proper risk-adjusted performance numbers (i.e. Jensen’s alpha), making them highly misleading. In a nutshell, our industry has been selling higher risk as skill. This cannot continue.

Even passive investing is extremely risky despite the fact that you will outperform about 85% of actively managed SA general equity funds. For example, the Top 40 index is highly undiversified and concentrated in industrial counters, so your drawdown or tail-risk is often extremely high.

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It’s easy to demonstrate, by looking at their holdings through different market cycles, that both passive and active strategies have been extremely poor at managing clients’ risk. For instance, hardly any SA balanced or absolute return funds meaningfully changed their asset allocation during, or after, the 2008 Global Financial Crisis. Similarly passive balanced funds, by definition, will do nothing during crises either.

During the last decade there has been a flurry of research papers that have uncovered innovative ways to better understand and model systemic risk (e.g. Hale et al 2011, Brunnermeier et al 2011, Kritzman et al 2010, Geanakoplos 2009, IMF 2010/2011a etc.). This type of research shows that a simple, reactive, rules-based strategy that changes one’s asset allocation whenever some risk metric like volatility (or market fragility) moves from ‘low’ to ‘high’ levels, adds significantly more value to clients than typical rigid active and passive balanced funds managed to achieve.

We believe that, instead of finding new ways to pick undervalued stocks, most large asset management companies will need to conduct R&D into how to manage risk better, requiring a new philosophy, as actively managed stock-picking is replaced by, top-down, active risk management. Research globally clearly shows that substantially more value can be added through smarter risk-management than trying to beat benchmarks by choosing, for example, Firstrand over NedBank in a portfolio.

Even absolute return funds have been a global disappointment in managing risk effectively because any proper risk attribution will show that 90% of the variability in returns is due to ‘unmanaged’ market risks with less than 10% attributable to manager skill.

2: Moving away from investment products to client solutions

Fund management businesses may believe that they are providing client-centric solutions, but selling funds is product-centric. Creating a house-view portfolio or value fund and selling this single fund to diverse investors with different risk tolerances and demands is the classic definition of a product, not a service.

Soon, our industry will standardise valuable returns from value or momentum investing styles with commoditised index strategies and combine these ‘Lego block’ portfolios into bespoke combinations for each client. This is a valuable service and a solution because it explicitly controls risk more efficiently by focusing on adapting client exposures to different risks at any time.

Smart fund managers will become assemblers of 3rd party risks, rather than portfolio manufacturers at instrument level. By being a useful risk allocator we also avoid the inevitable product commoditisation and price-war trap that traditional active and passive funds (i.e. products) are tainted with.

For example, BMW or Mercedes outsource every possible component of their vehicles allowing them to focus on styling, engine and chassis design. Clever investment businesses will do the same and not worry about which stocks to pick anymore.

3: Technology replaces human judgement in managing risk

Every major industry that has neglected technology, like publishing, film and music, is being driven to extinction by disruption from much smaller ‘high-tech’ companies.

A worrying fact is that large asset management companies have invested less in technology than any other industry of similar size over the last 20 years. Instead our industry spends most of its resources on people, especially those with great past performance that probably won’t persist into the future, rather than investing in building cutting-edge risk technology to create a real competitive advantage.

The ‘FinTech’ (Financial Technology) revolution has seen new technology-driven companies enter the market, with smart intellectual property able to build, execute and manage more efficient portfolios via algorithms, bypassing the need for fund managers.

A reason that large asset management firms have fallen behind in the tech-race is that they still need to accept that computers are better at managing risk than humans are. Markets are complex dynamic systems and no human can interpret or manage a portfolio effectively with so much information and rapid change.

Technology in cars and planes constantly warn the pilot or driver of their surroundings. We don’t have anything vaguely similar for fund managers to navigate through market storms. There is no research to show we can pick stocks very well but there is so much research and evidence that we can manage risk better, yet our industry ignores this.

Conclusion: The new active management

Investment houses need to design new actively managed funds that have explicit risk payoffs built in. Just selling ‘unconstrained’ equity or ‘absolute return’ doesn’t work anymore because there is nothing in them that you could not easily replicate using cheaper passive strategies. There is no competitive advantage in these commoditised strategies anymore.

The aeroplane and motor industries have for a long time invested much more on improving safety (e.g. airbags, ABS brakes, GPS, radar etc.) than increasing speed. As a result, massive strides have been made in vehicle and airline safety.

It is time the investment industry also tries to improve safety (risk) and focus less on speed (i.e. return). Already some are looking at ways to pay fund managers to reduce risk, not pay them to try and beat benchmarks with higher risk. We also need to stop spending the majority of our resources on marketing campaigns and chasing performance/skill based on highly unreliable historic returns (i.e. alpha).

Instead, just like Mercedes Benz or Volvo, successful asset managers of the future will create a competitive advantage by investing heavily in cutting-edge risk-management, or ‘portfolio sensor’ technology so they can adapt to changing market conditions much more quickly, reducing risk.

This requires a top-down modular portfolio construction approach that allows fund managers to buy and sell these commoditised risks directly, rather than worry about the earnings forecasts for Billiton or what the fair value for Naspers is.