On the first Friday in May, the chief investment officer of the Future Fund, Raphael Arndt, spoke about how it is refining its listed equities investment program. The primary concern was whether “they are paying for (active) managers’ stockpicking skill”. Arndt’s view was, “If we want factor exposures, we can access factor indices much more cheaply without paying active management fees.”
The primary catalyst for this thinking is that the Future Fund faces issues similar to all investors’ concerns. That is, considering the long-run outlook for investment returns is nothing more than single digits, fees are a high proportion of the total portfolio expected return, so any reduction in fees from increased efficiency will have a significant impact on final returns.
As a result, the Future Fund redefined the objectives of its $38 billion worth of listed equities into four categories:
1 | Capturing equity market risk
2 | Harvesting long-term equity factor premia
3 | Delivering uncorrelated, good,
skill-based returns
4 | Accessing desired exposures with
a whole-of-fund perspective
This article is not about explaining the direction of the Future Fund. The objective is to communicate the benefits of a deeper level of investment analysis than I believe is currently performed across our industry. The reason I mention the Future Fund’s listed equities program is that the overeign wealth fund is the most recent, and maybe most prominent, example of the application of what I call the fourth stage of investment analysis.
With improving technology, analytical tools, access to a greater depth and breadth of investment strategy, and the financial planning industry’s move towards managed accounts, it is probably time for advised portfolios to move to the fourth stage as well.
Successful application of the fourth stage of investment analysis is likely to increase the move towards designing investment portfolios that have a stronger reflection of our investment philosophy (or beliefs), and a more efficient allocation, with increased performance risk management.
The four stages
Stage 1 is pure performance analysis and is what most clients are solely focused on. It concerns the overall return result and perhaps the volatility. But whilst performance is typically a primary target, performance numbers alone provide little insight into whether an investment is truly good or bad. Looking only at performance often leads towards bad investment behaviours, such as selling low and buying high.
I would argue that most of the investment advisory community are at Stage 2, which is the assessment of the quality of an investment by comparing it with a benchmark … which often leads to the conclusion that outperformance is good and underperformance is bad. The choice of the benchmark is a critical part of this analysis and where most mistakes are made at Stage 2. Sometimes the benchmark is a peer group, which may be fine depending on the investment type but best practice suggests a benchmark should be a liquid representation of the underlying investment universe – typically a market-cap weighting of available investments.
Common benchmarks include the S&P/ASX 200 for Australian equities
or MSCI World Index for global equities.
If we believe that achieving higher returns requires the acceptance of higher risk, then outperformance alone may be a dangerous way of assessing whether an investment is good or bad. Strategies may outperform their benchmark over long periods of time not because they are necessarily skilful, but because they may be taking on lots of risk. A simple strategy example is a geared Australian Shares index fund … With the Australian sharemarket producing a performance of nearly 11 per cent a year over the last five years, an initial loan-to-value ratio of 50 per cent and borrowing costs at a high and fixed 5 per cent a year would have produced returns for the fund in the vicinity of 15 per cent a year. This outperformance has nothing to do with being skilful or good; it’s simply the result of accepting much greater risk than the market.
At Stage 3, analysts adjust for market risk and divide the portfolio’s risk into the two components we hear so much about … alpha and beta. Alpha is the market risk-adjusted outperformance often associated with measures of active management skill. Beta represents a strategy’s exposure to the market. For the above-mentioned geared Australian equities index example, the alpha should be slightly negative and close to the cost of the fund, whilst the beta (thanks to a loan-to-value ratio of 50 per cent), should be up to 2 … which represents twice the market exposure (or risk). Whilst the geared index strategy has strong outperformance, its
negative alpha suggests there is no skill because the return has been driven by having double
the market exposure.
Understanding an investment’s beta, or exposure to the market, is an essential part of portfolio construction, because this is the measure that helps determine the asset allocation’s role in a strategy. If we want to choose an investment that is fully representative, then its beta should be about 1.
If the strategy’s beta is less than 1, then that strategy may be holding a significant amount of cash, so it potentially compromises the desired asset allocation and reduces the portfolio’s goal of capturing the intended “equity risk premium”. A fund with an expected beta of less than 1 will underperform its benchmark in a strong bull market, unless there is significant skill (or alpha) and that is far from guaranteed. However, that skill may also be due to luck or perhaps styles or factor exposures that happen to be in favour over a period of time. This is where Stage 4 investment analysis may be required.
Stage 4 is where the Future Fund has arrived, along with many other institutions and sophisticated investment professionals. This stage further adjusts for non-market systematic risks, which are typically represented by the smart betas, which can be purchased somewhat cheaply. In English, typical smart beta exposures may include style indices such as value (for example, low PE ratios), size (for example, small caps), momentum (for example, last year’s best performers), quality (for example, high profitability and low debt), and others. With the growth of the exchange traded fund (ETF) market into these smart beta exposures, purchasing your preferred style of investing is getting easier. As Arndt of the Future Fund alluded to, purchasing factor exposures is cheaper than pure active management and may sometimes present a more efficient way of gaining desired exposures to reflect your investment philosophy (or beliefs) around what works in markets.
Stage 4 investment analysis explains which factor exposures (or smart betas) are driving portfolio outcomes, as well as the exposures to each. This means that the multi-factor alpha (see Chart 1 – Stage 4, facing page) is the pure alpha (or skill) a manager brings to a strategy and is the result of their success in security selection, market timing or, potentially, smart beta timing. Positive multi-factor alpha is the holy grail of active management and when you consider the cheaper access of market cap-weighted index funds and smart beta funds, positive multi-factor alpha is what investors should be paying the high fees for.
The Stage 4 investment analysis framework increases the chances of the portfolio constructor choosing investments that:
- Reflect one’s investment philosophy with demonstrated characteristics around desired
styles that are expected to outperform (smart betas/factors) - Reflect the desired asset allocation with demonstrated market exposure that is likely
to continue (market beta) - Have active managers with potential skill demonstrated by positive risk-adjusted outperformance (multi-factor alpha)
- Demonstrate a strategy is “true to label”; that is, the strategy’s market beta and smart beta exposures are consistent with the investment process the manager has communicated.
Whilst this is not the end of the portfolio construction or strategy selection process or story, implementing a Stage 4 investment analysis framework is a strong move towards a deeper understanding of portfolio risk drivers.
Understanding likely portfolio risk drivers means potentially greater efficiency, as risks can then be accepted, mitigated or even removed. It changes the manager selection or retention approach from one that’s return driven to one that’s risk driven. This enables strategy roles to be more specifically defined. When executed correctly, portfolios may have lower strategy turnover, therefore reduced investment costs, and therefore better returns.
Perhaps the next steps include answering the questions ‘What risks do I believe add value? and ‘How do I capture them and remove the ones I don’t believe in?’ This potentially brings us into the world of factor investing.
Michael Furey is the principal of Delta Research & Advisory.
