by Jay Kumar, September 2017.
- In a crowded market of active management, investors need to focus on unique drivers of alpha and assess their sustainability through a complete investment cycle.
- The recent proliferation of passive ETFs, fundamental-indexing and factor-tilting strategies have muddied the waters for active strategies, particularly around how they interact with each other if blended in a single structure.
- Active managers need to demonstrate their true edge using evidence-based framework. Asset investors require more than just a good story and performance attribution.
- Holdings-based factor analysis that uses a harmonised framework provides a compelling framework for benchmarking strategies against cap-weighted indices, smart-beta indices and focused peer groups.
- Applying a consistent, factor-based approach across market performance, peer groups, and individual portfolios can reveal valuable fundamental insights that have greater persistence, lower noise and comparability across strategies.
- These insights can help asset owners and fiduciaries reduce potential hiring and firing mistakes.
- Understanding the secular and cyclical factor biases in portfolios and contextualising their active orientation can help reduce performance-chasing behaviour by investors.
Flows into smart beta strategies have been significant. There are 27 ETPs in Australia with $2.2 billion in assets. When separate accounts and open-ended funds are accounted for, the asset size for the strategic beta segment is much larger.
Not all active managers are created equal
Assessing performance of active managers requires much more than just reviewing information ratios and Sharpe ratios. These are outcomes of portfolio biases, exposures and decisions that are driven by people and processes. This type of information needs to be complemented by human insight and objective fundamental analyses. The following analysis does show a wide variation across the peer group and provides a timely reminder that not all active managers are created equal.
High dispersion of active manager alpha is evident when risk-adjusted measures such as information ratio and Sharpe ratio are considered.
Fundamental benchmarking provides valuable insights
How are fund investors supposed to know which factors will be important for comparing thousands of equity funds when the underlying investment approaches are so different? How can they isolate funds that reflect their investment views? Trying to select which factors matter in equity markets has been a holy grail for finance practitioners for decades. The findings certainly suggest that anyone involved in creating or assessing investment funds might want to be more cautious before loading up on factors that emerge from academic papers and journals.
There are several essential considerations for factor selection and review. According to global factor analytics firm Style Research, factors should be measurable across most companies and not just explained by sector or country effects. They should have an intuitive economic rationale, should be evident across different markets and should be investable or liquid. They should also not just be a by-product of small or micro-cap performance as a result of an equally-weighted approach. And the factors ought to work for long-only investors. Many academic papers assume long-short strategies which are much less common in practice. These criteria are well known. But the factor selection also needs to be fair to all funds and not biased to one type of fund. This needs to be borne in mind when designing and selecting factors for a factor framework. The framework must be effective for both fund sellers and fund buyers to analyse and compare funds objectively and clearly (with lower level of noise).
Factor scores relative to the index shows both the direction and magnitude of factor tilts of a strategy. Factor tilts greater than or less than 1 denotes statistical significance. Factors can be grouped across value, growth, momentum, risk, quality and other.
The above factor skyline of Fidelity FIRST global equity strategy shows strong positive orientation towards short and long-term value factors. It also has strong tilts towards earnings revisions, 3-year volatility and quality factors. In addition, the portfolio’s market cap orientation is towards mid-small caps.
Factor scores relative to the index and peer group shows both the direction and magnitude of factor tilts of a strategy. Factor can be selected from factor groupings such as value, growth, momentum, risk, quality, ESG, Macro and other.
The index and peer relative chart shows the factor tilts over time. It shows that Fidelity FIRST portfolio is cheap relative to the index on Book to Price factor. Since 2016, Fidelity’s cheapness has improved both relative to the index and the peer group. The portfolio’s Book to Price has moved in the first quartile of the peer group universe. The second panel of the chart shows improving cheapness of Fidelity portfolio relative to the index and peer group on longer-term valuation factors such as CAPE (cyclically adjusted PE).
Active orientation of managers provides a useful context around factor biases and resulting performance cyclicality. Diversified stock picker orientation is highly popular for Global core managers.
The active orientation chart above shows the active risk profile of global core managers across two dimensions – active share and tracking error. The higher the tracking error for a given level of active share, the greater the cyclicality of alpha stream expected from the manager. Managers with high tracking error often have high unintended systematic factor bets (for example currency, market, interest rate risk) in their portfolio. These common factors often have long cycles and can be difficult to time. If you are backing managers for their strong stock picking skill then its best to pick managers with high active share and modest tracking error.