The opinion that investors should expect lower returns going forward is now widely publicised. Across almost every medium – TV, magazines, newspapers – managers and well-respected investors are talking about re-basing investor expectations lower. In the past few years, this has certainly been Zenith Investment Partners’ experience when talking with multi-asset managers.
While these calls have become increasingly loud, it’s important to realise that it isn’t a recently held view, with PIMCO’s “New Normal” moniker, coined in 2010, coming to epitomise this view. Intuitively, the view makes sense, given where cash rates fell
to and are expected to remain around the world; remembering that most asset class valuations are anchored off a risk-free rate (longer-term government bond rates) – therefore, lower risk-free rates translate to lower returns.
Despite this widely held view, if one looks back at how broadly diversified portfolios (see Table 1 for passive benchmark performance to September 2016 of various risk profiles in Zenith’s database) have performed in this era, investors could easily be forgiven for raising some questions about the validity of this view.
The above performance has contributed to the case for investing in index strategies. Quite
understandably, investors have asked why they would pay higher fees for active returns, when the above returns can be achieved through lower fee index options?
However, it should be remembered that these returns have been achieved in a world of decreasing and low or negative cash rates, abundant and expanding quantitative easing (QE) programs by the major central banks, and the low starting valuations of the post-crisis world.
It’s not wildly difficult to understand why the environment going forward will not resemble that of the recent past. The US Federal Reserve is likely to raise the cash rate imminently, many central bank QE programs are scheduled to wind down in the next few years and valuations are looking extremely stretched in an absolute sense. In October, one could argue that markets had already started to presage the impact that a higher US cash rate would have on asset class valuations, with the 10-year bond rising 0.25 per cent during the month.
So if investors accept that returns going forward will be lower than historically, then how can they improve overall portfolio returns? Zenith believes one way to do this is to place increased emphasis on sourcing alpha. Alpha is the excess return attributable to outperformance of passive indices, and in a multi-manager context, this arises from selecting superior managers/strategies. Zenith is not alone in doing this, having observed a greater willingness of our rated, multi-asset manager universe to include assumptions of alpha within their asset class forecasts. An obvious counter to this is that alpha is inconsistent and, as widely publicised, active manager performance has been disappointing in recent years. This fact has also strongly contributed to the significant flows into index strategies during this time.
One can argue why active management has been disappointing and why this may be different going forward. However, even without making this argument, it’s possible to identify asset classes and strategies where alpha has been more persistent in recent years and therefore we can identify where active management could contribute to portfolio returns. Chart 1 lays out the relative performance of the manager universe across Zenith’s
Australian Equities universe, broken down by strategy type, for the six years to June 2016 (secular bull market period).
It’s clearly evident that, in almost all strategies except large caps, the median manager has delivered strong alpha as well as positive absolute returns. If you made little assumption about one’s ability to select the best performing managers, it was possible to source alpha
in these strategies by just investing in the median manager. Not surprisingly, the most fertile areas for outperformance were the more inefficient segments of the market, namely small and micro-cap strategies.
These strategies don’t come without some negatives, however, namely higher volatility, greater illiquidity and capacity issues. On the latter issue, while limited capacity (capped levels of assets of management) can create some administration burden for advisers, it can also be a point of differentiation, as this size constraint generally limits institutional
investor involvement.
Another area where Zenith believes investors can source alpha is in alternatives. While this encapsulates a wide spectrum of strategies, we restrict our definition to “liquid” alternatives, chiefly global macro, managed futures and market neutral. Chart 2 lays out the performance of the manager universe in Zenith’s database, across these strategy types, for the nine years to June 2016. This time period has been chosen to incorporate the global financial crisis, as the value-add of these strategies is borne out particularly well in a stressed market environment.
An important caveat
It’s important to note that, in this instance, Zenith’s definition of alpha is potentially a point of contention, as we have chosen the average bank bill rate over this period, plus 3 per cent as we believe, in the environment going forward, this represents a reasonable return outcome.
As can be observed, the median manager in the managed futures and market neutral space
comfortably outperformed this hurdle over the time period. The obvious standout is the global macro space, where the median manager has not outperformed this hurdle. The performance difficulties of these strategies and the reasons for this subpar performance have been widely publicised. Cognisant of this, Zenith has sought to access this type of investing through the newer style, global multi-asset strategies such as the Invesco Global Targeted Returns Fund and Standard Life Global Absolute Return Strategies Trust. These
Funds employ similar strategies as traditional global macro funds but have lower fee structures, in our view removing a significant hurdle to this outperformance. Historical performance of these strategies has been strong, albeit only in the post-GFC environment. The above takes into account only performance, but historically these strategies have
provided strong diversification benefits as well.
In conclusion, given the tailwinds of recent history, index-style investing has enjoyed a strong period of performance. However, in the environment going forward, returns are expected be lower as these tailwinds are removed. For this reason, Zenith believes that investors will need to rely more on alpha to improve portfolio outcomes. As such, alpha will become an increasingly larger contributor to overall portfolio returns.
