Is alpha at an end?
The holy grail of active investing has always been alpha, the excess return of active investing over passive investing. Research suggests the era of alpha is over, but it’s not as simple as it seems.
Earlier research claims two-thirds of active Australian equity managers are not delivering alpha, net of fees1.
The assertion might be right, but behind it is a much more complicated story.
Active Australian equity managers have performed below expectations over the past five years. It has led to significant mandates being pulled from active managers and a switch to passive and factor-based investing. Not helping is investor sentiment towards being underweight on Australian equities.
Considering the performance, it should come as no surprise then that ‘mega funds’ have pulled mandates. The market is sufficiently small that when you scale you quickly become the market. This means it is difficult to generate reliable alpha at this size while paying active fees to a number of core managers.
At AMP Capital, we believe there are strong pockets of alpha to be found in the Australian market for those managers that are looking in the right places and correctly tailoring their approaches.
Benchmark-aware strategies have struggled
Alpha does exist in the Australian market although it is not as broad-based as it once was.
Over the past five years, we have observed a noticeable decay in the alpha of benchmark-aware strategies of all styles. Long-only or long-short, growth or value, small-cap, large-cap and others; all have experienced the same fate. According to the MercerInsight® database, one-year alpha of the median Australian shares manager is at record low levels over the available history which almost stretches back as far as the formation of the Australian Securities Exchange which was in 1987.
On the upside, we are instead seeing strong pockets of alpha among concentrated managers that employ hybrid ex-50 strategies, which is how we manage the AMP Capital funds. These high alpha strategies typically have limits of around $3-$5 billion, due to the relatively small size of this asset pool.
High alpha for all sizes is a matter of technique
Alpha in the Australian market does not scale well.
This means that when managing larger assets, there is no effective ‘lift-and-shift’ or upsizing of investment strategies. High alpha strategies that work for smaller investments can’t be borrowed and applied to larger ones. They just don’t fit.
What that means for the mega super funds and industry funds out there is that there are limitations to extracting alpha from the market. When you are already such a large slice of the market, it is difficult to be in the pockets of the market that are conducive to alpha.
Instead, there is a technique to building specific high alpha strategies for larger assets. Typically done in increments of around $10 billion, they also come with nuances to avoid over-diversification while gaining access to top quartile managers at low fees.
The strategy we observed elsewhere in the marketplace was to employ a collection of benchmark-aware managers. The funds that did this are typically the ones that have underperformed in the last five years. Investors have subsequently replaced them and gone passive or terminated them.
At AMP Capital, our approach to managing large Australian equity funds is to have a high alpha bucket and an enhanced quant bucket. Such an approach avoids most core managers, instead selecting managers that take large active positions or have exposure to ex-50 companies diversified with enhanced quantitative strategies. In terms of the fee structure, this kind of ‘barbell’ approach avoids paying active fees for no alpha.
AMP Capital’s MySuper and Future Directions funds employ a style where we commonly have a 50-50 barbell setup of enhanced and high alpha strategies; 50% enhanced and 50% active. We only hold concentrated managers and have a sizeable exposure to the ex-50.
This approach offers a blend of long-horizon, high-conviction fundamental managers with short-horizon quantitative strategies. Further, by maximising active share, this balance of managers avoids the excessive diversification that comes with investing in a set of core managers.
In-house investing takes commitment
Another matter is that of large funds bringing some or all of their investment teams in-house. Industry super funds internalising their investment teams is a new territory that is largely untested, bringing additional operational complexity without the guarantee that they will deliver better performance.
The maturity of the operation has a lot to do with how resilient it will be when performance falls short; in particular, its governance capability to assess or replace internal investment teams and determine how the fund will recover. If you decide to wear both hats, you can’t fire yourself if something goes wrong.
AMP Capital employs internal and external investment teams. Most of our external managers are near capacity or closed and have not experienced major cash outflows, implying there is no threat to their business models from internalisation, and our internal managers are well positioned relative to internal super fund managers.
For us, mature governance means subjecting internal managers to the same scrutiny as external managers, which is where we have an advantage. We continually assess our internal managers to determine whether their capabilities are institutional quality and have established processes to manage the environment.
For instance, we have a multi-manager group that manages and researches funds. This includes our internal investment teams, which are assessed against long-term success factors to see whether they are appropriate at the multi-manager level. Once a manager is selected, they are continually monitored for any significant events including changes in the team or process. Such events would lead to the initiation of a formal manager review from which a course of actions is developed to avoid a deterioration in performance.
For large funds that may be thinking about internalising their investment teams, there’s an argument that the fund will be able to save cost and pass that on as reduced fees. By using our internal teams, we believe we bring the same advantage – cost advantage, the ability to customise mandates, and access to information and portfolio managers – plus the governance to deal with situations that arise from things not performing to plan.
While Australian equities are a narrow market, pockets of alpha still exist, but have become more difficult to extract.
Individuals are unable to directly access many of the top quartile managers that have had success and quickly become closed to new investment. These capacity constraints mean that alpha doesn’t scale well in the Australian equity market.
A team of professionals that have a process and track record of investing in top quartile managers before they close could assist an investor in finding the alpha in the Australian equity market.
1 Ronald N. Kahn & Michael Lemmon (2016) The Asset Manager’s Dilemma: How Smart Beta Is Disrupting the Investment Management Industry, Financial Analysts Journal, 72:1, 15-20, DOI: 10.2469/faj.v72.n1.1
Author: Duy To, Portfolio Manager Sydney, Australia
Source: AMP Capital 16 Sept 2019
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Source: Market Updates