Investors should be examining the drivers of active return from managers – in other words monitoring exactly what they are paying for. And now with the help of a study by MSCI, investors can compare the extent to which factors and stock selection are driving active returns, making it easier for them to evaluate managers’ skill.

A new paper by MSCI, Anatomy of active portfolios, looks at the attribution of active performance – that is, above the benchmark or beta performance – and finds that factors contribute more than half of active return.

The authors examined five-year active performance data from 1315 diversified active global and international mutual funds over 13 years from September 2003 to December 2016. They found that for the top-performing funds, 55 per cent of active return was due to factors and 45 per cent was from stock selection.

“In short, we found that, based on absolute contribution fractions, 16 style factors, collectively, had the largest impact on a typical fund’s performance,” authors Leon Roisenberg, Raman Aylur Subramanian and George Bonne, from MSCI, state.

Given this finding, that more than 50 per cent of active return is due to factors, rather than skill, investors could reconsider what they are paying for and how much it’s worth.

The study found that most funds had a significant exposure to factor groups, which it defines as including country, industry, style and currency. And among these factor groups, style had the largest impact on active performance, with 34 per cent of factor returns, on average, attributed to style.

Among the individual styles, size and growth had the biggest impact, with 63 per cent of funds benefiting from a positive contribution from both of those. This was followed by momentum (which gave 60 per cent of funds a positive contribution), quality (53 per cent) and value (46 per cent).

MSCI’s in-depth analysis of the contribution of style factors to active performance also raises questions about the ability of managers to be true to label. For example, the study found that, for value managers, the active return contributions from volatility, price momentum and profitability factors each accounted for more than the value factor, which contributed 15 per cent of the total style contribution, compared with 19 per cent, 18 per cent and 17 per cent, respectively, from the other factors.

The paper reports that while active funds had a significant exposure to their target, or stated factors, such as value, most funds also had a significant exposure to other factors. This suggests the need for a benchmark that is consistent with a fund’s stated objectives, which would help highlight the drivers of performance.

The paper shows that over the entire period measured, the average trailing five-year active performance was 73 basis points a year, before transaction costs and fees. It doesn’t consider the returns after costs and fees.

Outperformance tougher than thought

Another recent academic study, Why indexing works, shows that outperforming the benchmark is more challenging for active managers than previously thought, regardless of fees.

This paper’s authors – from Chicago Booth School of Business, Oxford University, and law firm, Bartlit Beck Herman Palenchar & Scott – state that active equity managers often find it difficult to keep up with the benchmark, let alone outperform it.

They say previous research has focused primarily on fees as the cost of active management. Instead, they present a model that suggests the much higher cost of active management may be the inherently high chance of underperformance that comes with attempts to select stocks.

“One reason indexing works so well,” the paper states, “is that, on average it seems, active management faces a higher hurdle than previously recognised. Missing (or underweighting) the securities that significantly outperform other securities is a strong headwind for an active manager to overcome. This view of the active-passive problem helps us understand the mystery of how so many smart people, with enormous financial and informational resources, systematically do such a poor job investing money.

“To the extent that those allocating assets have assumed that the only cost of active investing above indexing is the cost of the active manager in fees, that assumption should be revisited. Active managers do not start out [on] an even playing field with passive investing…Put another way, passive investing may have a larger head start on active investing than previously believed. When creating a portfolio combining passive and active strategies, independently of past performance, return estimation should be adjusted for the inherent statistical disadvantage of the active manager combined with the higher fees.”

 

Investors should expect to continue to earn an equity risk premium comparable to a 3.8 per cent historical long-term average, based on new analysis that quantifies the effect of share buybacks – and the decline of dividends – as a major driver of equity returns.

An article by the head of capital markets and asset allocation at Morningstar Investment Management, Philip Straehl, and Professor in the Practice Emeritus of Finance at the Yale School of Management, Roger Ibbotson, highlights the importance of including share buybacks in calculating a “payout yield” for equities.

In the article, “The Long-run Drivers of Stock Returns: Total payouts and the real economy”, published in the Financial Analysts Journal, Straehl and Ibbotson argue the importance of share buybacks is often overlooked but their impact on equity returns can no longer be ignored.

In the July 2017 edition of The Ambachtsheer Letter, KPA Advisory Services’ Keith Ambachtsheer says the good news for investors is that based on what he believes is a reasonable set of assumptions underpinning equity return forecasts by Straehl and Ibbotson, “forward-looking equity risk premium today looks a lot like its historical counterpart”.

Danger of underestimating future returns

Getting an accurate and meaningful bead on the equity risk premium remains of prime concern for long-term investors seeking to allocate capital efficiently across different asset classes and varying periods of time. Opinions remain divided on what the figure is, and even on a suitable definition.

The traditional and widespread approach to forecasting returns using dividend yield and expected growth in dividends, while ignoring buybacks, will cause future returns to be underestimated, Ambachtsheer says.

As the importance of share buybacks becomes better understood and is factored into calculations, the effect of potential underestimation becomes clearer.

The Straehl and Ibbotson FAJ article states “the cash flows that corporations supply are the ultimate drivers of stock returns”, and since the early 1980s, buybacks have become an increasingly important part of that supply, exceeding dividends in eight of the last 10 calendar years.

What matters, the article states, is the combination of dividends and buybacks, and buybacks have “a fundamentally different impact on the return generation process than dividends”.

Dividends result in cash in the investor’s pocket, whereas buybacks affect growth by increasing the equity price return for buy-and-hold investors, whose stake in a company increases. Not taking this price growth into account can be a factor in underestimating future returns.

“The advent of share buybacks as the dominant form of payout has created a need for a new set of return models that are independent of the payout method,” the FAJ article states.

Buybacks’ growing importance

In analysing the return from US stocks for the period 1871 to 2014, Straehl and Ibbotson based their calculations on a dividend yield of 4.5 per cent a year, buyback growth (BBgrowth) of 0.8 per cent a year and dividend growth of 1.5 per cent a year – giving a real return of 6.8 per cent a year. However, looking ahead, they base their estimates on a current dividend yield of just 1.9 per cent and buyback growth of 1.7 per cent, the average of the last 10 years.

Ambachtsheer says: “A key message in the [Straehl and Ibbotson] article is that, based on the assumed continuation of the average share buyback experience of the last 10 years, the BBGrowth factor is almost as important as the current dividend yield in calculating the expected long-term return of a broadly based equity portfolio today.”

The Ambachtsheer Letter states that the historical 6.8 per cent a year long-term real return from US equities and the 3 per cent real return from US Treasury bonds implies a historical equity risk premium of 3.8 per cent. However, today’s real bond return is about 0.8 per cent, implying an equity risk premium of 4.4 per cent – based on the average of Straehl and Ibbotson’s forecast of a real return from US equities of 5.1 per cent and what Ambachtsheer says is the projected 5.3 per cent from the S&P 500 Index.

Ambachtsheer says Straehl and Ibbotson’s payout yield calculations support his own analysis that with bond yields at their current levels “the prospects for earning a positive equity risk premium…continue to be good at today’s stock price levels”.

He says bond yields could rise to 1.4 per cent before they begin to affect the 3.8 per cent historical equity risk premium. But the factors depressing bond yields are secular in nature and “unlikely to be reversed any time soon”, he argues, and investors will continue to earn an equity risk premium at or near historical levels.

In 2011, the Research Foundation of the CFA Institute published a collection of papers, Rethinking the Equity Risk Premium, which contained the results of 19 separate studies calculating the equity risk premium in a range between zero and 7 per cent.

“The papers collected in this volume share a general emphasis on supply factors and models for the historical excess return as well as the forward-looking equity risk premium,” the CFA Institute publication states. “After 10 years of low and highly volatile equity returns, there is little consensus about the stability of the [equity risk premium] over changing regimes and time horizons. Interestingly, the group appears to be in agreement more on the actual size of the ERP over the next few years (most agree that it is in the 4 per cent range) than on its stability.”

The causal link between good governance and investment performance has been an elusive domain for financial services academics. Now, in Switzerland, some progress.

A study of 139 Swiss occupational pension plans shows, empirically, governance is positively related to excess returns, benchmark outperformance and Sharpe ratios.

The paper, Is Governance Related to Investment Performance and Asset Allocation? Empirical evidence from Swiss pension funds, investigates the relationship between governance, investment performance and asset allocation at pension funds in Switzerland.

Study authors Manuel Ammann and Christian Ehmann, from the University of St. Gallen, find that fund governance is positively related to investment performance, but only marginally related to funds’ asset choices.

The paper doesn’t give any indication of the direction of causality, but it does show that good governance pertaining to target-setting, defining investment strategy, and risk-management design is positively related to both excess and risk-adjusted net returns.

The academics developed a metric comprising six different governance areas: attributes of organisational design, management incentives, target-setting and investment strategy, investment processes, risk management, and managerial transparency.

The study finds that pension funds in the top governance quartile outperform those in the bottom quartile by about 1 per cent, related to average excess returns and benchmark deviation. It also shows that a clear, written statement specifying organisational goals and strategic targets is positively related to passive benchmark outperformance.

Asset allocation decisions are not related to governance, the study finds, but rather to institutional factors such as size, legal form and the ratio of active managers to pensioners.

The full report can be accessed here:

Is governance related to investment performance and asset allocation? Empirical evidence from Swiss pension funds

Diversification benefits are demonstrated in the returns of two large investors with complex portfolios: the Government Pension Investment Fund (GPIF) of Japan, and the Abu Dhabi Investment Authority (ADIA).

Both have large portfolios but they differ in their history of investing. GPIF is only at the beginning of its journey towards diversifying its holdings, while ADIA has a long history of investing in private equity, real estate, infrastructure, alternatives and equities, across both the capitalisation spectrum and various geographies.

GPIF returned 5.86 per cent for its fiscal year 2016, and has generated an annual rate of return of 2.89 per cent since inception. The fund, which now has funds under management of ¥144.9 trillion ($1.3 trillion), attributed its annual return to the positive impact of domestic and international equities.

For the year to the end of March 2017 (GPIF’s latest fiscal year) its domestic equities portfolio returned 14.89 per cent, foreign equities returned 14.2 per cent, and domestic bonds returned -0.85 per cent.

Historically, the fund has had a simple, conservative asset allocation, including a large holding in bonds, particularly domestic bonds. It is only now starting to diversify into equities, and holds no private or alternative assets. Over the last two years, it has decreased its allocation to domestic bonds by 10 per cent, re-allocating to domestic and international equities, which together now make up nearly half of the portfolio.

GPIF has made the unique statement that its investment horizon is 100 years; however, it allows its external managers to determine the holding period of their investments.

Meanwhile, the Abu Dhabi Investment Authority has a much more diversified portfolio. It has generated a return of 6.9 per cent a year over the 30 years to the end of December 2016. The 30-year return was 7.5 per cent at the end of 2015.

ADIA’s long-term policy portfolio asset allocation is developed equities (32-42 per cent), emerging market equities (10-20 per cent), small-cap equities (1-5 per cent), government bonds (10-20 per cent), credit (5-10 per cent), alternatives including hedge funds and managed futures (5-10 per cent), real estate (5-10 per cent), private equity (2-8 per cent), infrastructure (1-5 per cent) and cash (0-10 per cent).

In 2016, ADIA got positive results from its decision to expand its investment universe within the alternatives portfolio, allowing co-investments alongside managers in special situations, along with investments in smaller, capacity-constrained managers.

It also launched an emerging opportunities mandate to invest in asset types that fall outside the remit of ADIA’s other investment departments. It is expected to execute its first such investment this year, with a view to adding differentiated return streams and diversification to the total portfolio.

GPIF’s assets are all managed by external managers, whereas about 60 per cent of ADIA’s assets are managed externally.

Strategy at Denmark’s $15 billion insurer SEB Pension is focused on building a robust alternatives portfolio within a risk-proofing investment approach, the fund’s chief investment officer, Jørn Styczen, explains.

SEB, a defined-contribution (DC) multi-employer pension provider, offers guaranteed and non-guaranteed DC pensions. Assets under management have increased on the back of growth in Danish demand for non-guaranteed products.

A quarter of SEB’s assets are invested in an alternatives portfolio established in 2000, which has since grown to become one of the biggest allocations to alternatives amongst its European peers. It is here, Styczen explains, where he is prepared to spend parts of his risk and cost budgets, using active external management in allocations to distressed debt, senior secured loans, hybrid mezzanine funds, infrastructure and private equity.

Recent strategies include investing in senior secured loans through 2015 and 2016 while being short high yield, in a bid to protect the fund from geopolitical risk.

“2016 was not the best year to be short high yield and long loans, but loans have protected the fund against geopolitical risk and as the yield spreads currently are nil, loans are very attractive,” he says.

Along with loans, infrastructure is also a big allocation within the alternatives portfolio. Here, Styczen prefers value-added opportunities, rather than infrastructure that “just gives income”, like a toll road. He also favours strategies and managers that go one step further than simply “buying the asset”. An example is SEB’s investment with Copenhagen Infrastructure Partners in a new biomass-fired combined heat and power plant in the UK. The plant is set to generate enough energy for 50,000 homes when complete in 2018.

Copenhagen Infrastructure Partners typically taps the mezzanine part of the market; however, Styczen also invests with Global Infrastructure Partners and EQT, where assets are structured more like private equity. SEB received a 30 per cent return from its infrastructure allocation in 2016, due to mature funds “selling assets”. Infrastructure investments have already returned 4.3 per cent in 2017.

Side-cars address fees

The large alternatives allocation makes tackling high fees an ongoing priority. One way to achieve this is through co-investment with SEB’s prime managers, setting up side-car arrangements.

“Our managers increasingly set up a side-car vehicle, whereby we invest, say, $50 million [through] the fund, and $30 million [through] the side-car. It allows us to reduce our fees by 25-30 per cent.”

He adds that because SEB’s total portfolio is already well diversified by asset classes and managers, any loss of diversification from this strategy “is not a problem”.

Styczen says the alternatives portfolio is a stalwart in the face of today’s geopolitical uncertainty and high debt levels, and plans to build the allocation further.

“We have the expertise to commit more to alternatives,” he says. Recalling the global financial crisis, he notes the alternatives allocation withstood the crisis because SEB didn’t have to sell any assets and “all the values came back”.

Along with the 25 per cent allocation to alternatives, SEB has a 25 per cent allocation to listed equities, a 10 per cent allocation to real estate and a 40 per cent allocation to liquid credit, Danish mortgages and government bonds.

Liability management stays in house

Across the fixed income portfolio, SEB has developed a liability matching overlay. This enables managers of SEB’s only active external fixed income mandate to focus on the benchmark.

“When we outsource the fixed income portfolio, we don’t outsource the liability management,” Styczen explains. “We watch it all the time ourselves and adjust our hedge to make sure the duration is in line with our liabilities and expectations. It is much easier for the asset managers if you don’t give them liability targets, you just give them the benchmark.

“Large fixed income allocations are challenging because the returns are so low. This way we can do the duration matching as an overlay.”

The bulk of the equity allocation is indexed, with a derivative overlay, in a low-cost strategy that has allowed the fund largely to eschew active equity management and hedge funds. The exceptions are one active mandate to Danish equities, which accounts for 10 per cent of the equity allocation, plus two active, niche equity strategies.

Styczen has also developed a risk premia program to work alongside the equity allocation.

“Most smart beta or risk premia strategies are correlated to equity; if equity markets fall, you can lose money in a smart beta portfolio, and the strategies are difficult to view as separate asset classes,” he says.

SEB’s solution is to use part of the risk premia program alongside the equity portfolio and replace some equity exposure with short volatility strategies.

“We need something that works better with the equity,” he concludes.

A recent innovation included developing a tail risk-hedging portfolio in response to the geopolitical uncertainty of Brexit and the new Trump administration.

“It was successful but it proved very expensive when there wasn’t any volatility,” he says. “A tail risk hedge doesn’t work if nothing happens.”

Still keen to protect against geopolitical risk, but loath to reduce the equity allocation, and with risk “uncompetitive”, Styczen has now decided to restructure the risk-factor portfolio and add a defensive tilt to make it work alongside the tail-risk portfolio. To this end, SEB is developing a number of defensive strategies that would give a large gain should equity markets fall.

Donald Pierce, chief investment officer of the $9 billion San Bernardino County Employees’ Retirement Association (SBCERA), brings vision and a steady hand to investment strategy.

The portfolio he shapes is built around low equity exposure and diversification, with assets chosen according to their value, along with their contractual and income qualities. All SBCERA investments are viewed through these three lenses, in a blueprint that runs throughout the portfolio. This explains the chunky allocation to alternatives, the preference for debt instruments and the fund being “grouchy” about equity without dividends attached, Pierce says.

Value means buying assets at a significant discount to what they’re worth. A principle recently challenged in the California-based fund’s emerging-market debt portfolio by the sell-off in Brazil, which has tested the mettle of most credit investors.

“Brazil sold off, we bought in and it got worse,” says Pierce, a United States Air Force veteran who saw active service in the Gulf War fresh out of high school. “When you are interested in an area that has been beaten down, it doesn’t mean as soon as you enter it won’t get beaten down more. And the one time you avoid the first round, you can guarantee it will rally on you and you’ll get mad at yourself.”

The portfolio’s contract and income principles mean SBCERA favours assets containing contracts that at some point in time settle up or pay money back to investors.

“Benjamin Graham’s The Intelligent Investor talks about buying assets below intrinsic value, yet one of the things rarely talked about – which we take to heart – is that the market may never take you out of your position,” Pierce says, in reference to Graham’s 1949 book, which is a bible for value investors.

It means he hunts for assets that extract value through cash flows and don’t ultimately rely on market movements for a return. There is always a danger that the market won’t move. In that case, embedded contracts ensure payment of some kind, at some point, “if push comes to shove”.

These principles sit easily within alternative assets, where the fund has allocations to timber, infrastructure and private equity. Rather than focus on the individual assets, Pierce looks at their components.

“Is it equity or is it debt? Does it have leverage? When does the debt facility mature? Is there a significant amount of asset coverage? Each asset we have we would like to underwrite in some way,” he explains. “It is much more of an underwriting story than an alternative story. The income is the least volatile of those components. The price change is where the action is, but it is also where all the volatility is.”

Pierce, who succeeded his mentor, Tim Barrett, in 2010, has introduced new allocations to international private equity and emerging-market debt, as well as option strategies and a wide-ranging rebalancing program. Here, the portfolio’s allocation is adjusted every month, according to asset prices, within a fixed range.

“It doesn’t change that much; we are a low-turnover portfolio. However, the main criticism I have of any strategic asset allocation [when] folks don’t change it, is that they are saying the price of the asset they are purchasing doesn’t matter. If your asset allocation doesn’t change when the stock price and value have increased by 200 per cent ov

er the last seven or eight years, you are saying the price at which you buy assets isn’t [relevant] to your asset allocation and this doesn’t make sense.”

Cash pile

Accessing assets that combine value, income and contractual elements is a challenge in today’s climate. Couple that with some large sums coming back to the fund from maturing private-equity investments, and it means SBCERA sits on a cash pile amounting to almost 10 per cent of its assets.

“It definitely feels like a weight,” Pierce says. “We are finding it harder to deploy capital in a way that meets our cost of capital and this is reflective of the opportunities out in the marketplace. Spreads are tight, equity is rich, and while there are some isolated areas that are interesting, they are not areas you can lean into meaningfully. And, of course, as the market continues to rally, holding cash doesn’t look like a good idea.”

The cash pile has roughly doubled from its June 2016 proportion of 4.8 per cent. At that time, SBCERA had a quarter of its assets in the alternatives portfolio, with equity (33.6 per cent) fixed income and credit strategies (29.1 per cent) and real estate (6.7 per cent) forming the other allocations.

Managers and fees

SBCERA uses 50-60 managers, but “actively engages” with about 15 of them. The strongest relationships within this group are with managers that “truly understand” SBCERA’s investment philosophy. It is this select cohort that plays a key role in bringing new ideas to the fund.

“Our best managers come to us only with assets we like and have taken our investment approach to heart,” Pierce says. “That said, we do use managers that cause us to stretch away from these principles, test our predilections and bring real diversification. This is particularly related to growth equity, which doesn’t tend to fall into our philosophy of value, income or contractual.”

He likes managers that welcome investor input and are prepared to let him upsize various ideas and “add-on positions”.

“When managers that don’t always ask us for money do ask, it usually makes sense” he says. “When someone is always asking for money, then that is not the partnership we are looking for.”

He also runs a highly collaborative “standing table call-in” process where co-investment decisions involving managers include all investment staff on the call.

“All the co-investment decisions that come through involve the entire team, hands on deck.”

Investment management and performance fees in the alternatives portfolio came in at $47 million in 2016, out of a total investment managers’ bill for the year of $62 million.

Reducing fees is hard in buoyant markets, but Pierce cites examples of successfully securing better fees by working with managers on specific asset structures, such as risk-retention vehicles. He also argues that opportunities to invest with SBCERA are rare.

“It is hard to get into our portfolio, so when it opens up, it is important they agree to our terms.”

Strategy also includes the freedom to invest without constantly referring back to the board.

“We ask for a lot of permissions up front,” he says, although he is quick to nod to the board’s expertise.

“Have I ever had a brushback pitch?” he says, referring to when the board ditches an idea. “There isn’t a CIO out there who hasn’t had one of their ideas shown the exit. In some ways, this is better than if it gets in the portfolio, particularly if you [would have spent a lot of political capital defending something that] doesn’t work. At this point, either you kill it or the board will kill it. It’s a humbling business.”