Manager selection is a core component of multi-asset portfolios. While asset allocation accounts for most of the returns over the long term, implementation can also generate alpha — and allow portfolio managers to cover a substantial portion of their fees — something that passive vehicles can’t achieve.
Over the last few years though, investors searching for cheap solutions have put pressure on active managers. The relatively poor alpha generated by active managers in this cycle has amplified this trend, especially in 2016, a year of multiple sector and style rotations.
While the flood of plain-vanilla exchange-traded funds (ETFs) and smart beta funds means portfolio managers now have more tools at their disposal, these implements did not replace active management.
Skilled and experienced portfolio managers remain critical to multi-asset portfolios. This is especially true in down markets, when the opportunity to generate alpha from implementation is at its height.
This has increased the importance of manager selection: choosing “true” active managers and understanding the factor and style dynamics that the blend of different managers creates in a portfolio.
In fact, active management — alpha — is simply the excess return over a style or factor return, also referred to as premia, with the latter representing the excess return over the index, or beta:
Total Return = Beta + Premia + Alpha
Beta and premia often dominate returns generated from implementation, so monitoring and controlling the factor exposure of a manager or managers is vital. There are numerous examples of managers with good track records who lagged over a particular stage of a cycle or even over an entire cycle.
Finding a good manager in a good structure with a proven track record is the easy part of the process. The hard part is style analysis and understanding the factors that are embedded in a manager’s portfolio. And that’s what makes the difference and enables alpha generation.
Factor, Style, and Premia Analysis
Active management is an improved version of smart beta. Both try to capture a style or a premia. The difference is that active managers can add alpha. Understanding this is critical: An active manager who doesn’t add alpha becomes a very expensive smart beta.
Thanks to smart beta and cheap trackers, investors can now access premia and styles in a very price-efficient way. Since total return is the sum of a beta exposure, a premia, and active management, an investor must make sure the fund they are buying is priced in proportion to the alpha generated.
Imagine a Europe-based investor looking to build an exposure to US value and growth styles who believes that active management can produce alpha and is considering the options available.
The cost of beta exposure in the US market is 7 bps via the iShares Core S&P 500 ETF 1. The large-cap US value premia can be accessed with a cost of 20 bps through the UBS MSCI USA Value ETF 2. So accessing the value premia costs 13 bps. The investor then considers the active exposure through one of the three largest US large-cap value UCITs funds by AUM within the Morningstar category3:
It is clear from the above example that cost should not be the criteria for fund or manager selection. The cheapest fund on the list delivered the smallest alpha over five years. Adjusted to fees, the alpha is negative.
But what about the growth exposure?
The premia delivered outperfomance over the five-year period. By paying an extra 12 bps for the premia, the investor receives 1.4% of outperformance each year over the last five years compared to the beta. The fee represented 8.6% of the gross alpha generated. In context, that is very attractive.
The picture on active exposure is somewhat different. The three largest US growth funds in the Morningstar peer group7, have a large performance gap. When comparing the alpha generated by these managers to the fees they collected, once again, the cheapest manager underperformed while the most expensive covered their ongoing charges.
The investor should, however, be able to differentiate among managers. The Morningstar US large-cap growth peer group is not homogeneous. While some of the managers have a quality-growth bias, others have a high-growth or growth-at-any-price approach. Only a good fund selector who is familiar with the fund universe could draw distinctions among the managers and relate them to the current market environment to know what type will be the most appropriate for the portfolio.
Looking at Growth Fund 3, the manager has a quality-growth bias, a style that was not in favor in 2017 and detracted from alpha over that year, lowering the three-year and five-year numbers. As of December 2016, this manager’s performance was very strong, benefiting from investors’ appetite for this kind of stocks over the previous five years.
No Substitute for Active Management
So what’s the takeaway?
Cheap ETFs and smart beta products are no substitutes for active management. But the manager-selection industry needs to adapt to the changing environment and investors’ price sensitivity.
A strong manager-selection framework is essential in analyzing a fund’s style and fees relative to expected alpha.
Investors today are questioning the need for active management. While it is hard for active managers to compete against momentum in strong, up-market rallies, they are expected to generate most of their alpha at the latest stage of the cycle, when markets sell off and momentum brakes.
Each day is bringing us closer to that moment of truth, when the alpha’s proportion of total return is greater than the beta’s. That will be the ideal environment to stress test each component of a multi-asset portfolio, from asset allocation to manager selection.
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- The iShares Core S&P 500 ETF has one of the longest track records in Europe tracking the S&P 500 Index.
- The UBS MSCI USA Value ETF has the longest track record in Europe tracking a US large-cap value index.
- Morningstar peer group: EAA fund US Large-Cap Value Equity. Data as of 31 December 2017.
- Performance net of fees as of 31 December 2017 — Source: Morningstar. Three- and five-year performance numbers are annualized.
- Performance gross of fees as of 31 December 2017. Three- and five-year performance numbers are annualized.
- The Lyxor Russell 1000 growth ETF has the longest track records in Europe tracking a US large-cap growth index. Five-year performance number calculated by subtracting the ETF’s TER from the Russell 1000 Growth Index five-year performance.
- Morningstar peer group: EAA fund US Large-Cap Growth Equity. Data as of 31 December 2017.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images/MHJ