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Alpha waves

Not so long ago, the word alpha was being bandied about the investment world with great alacrity. It remains an issue today, even as the demand for positive returns over relative has increased. The events of the past three years have certainly challenged the ability of active fund managers to achieve a greater return than their respective benchmarks.

Higher fees for added alpha remain a common industry justification. But at the same time, passive funds have also returned to centre stage as investors question the wisdom of paying more for funds which may outperform an index but still lose money.

FundQuest, a subsidiary of BNP Paribas which includes a UK funds of funds’ operation, recently completed a research paper examining alpha and beta, comparing the historical benefits of active v index-based passive portfolio management in 60 categories of investments.

The research, designed to act as a reference tool for portfolio construction, examines the historical performance of over 30,435 US-domiciled mutual funds representing almost $4tn of assets. The 60 fund categories include stock, bond, domestic and international mutual funds and covers all the funds in the Morningstar database from 1994 to 2008.

The study highlights that generally, active managers generated more real alpha in bull markets and less in bear markets during the 13-year period. Unsurprisingly, it was the growth categories that did better in bull market conditions while value produced greater alpha results in bear markets.

Many active managers assessed in the international FundQuest study attributed some of their lacklustre alpha to panicked investors pulling out of funds during the difficult times. Certainly, outflows would have made achieving performance more difficult last year. FundQuest noted that in 2008, actively managed stock funds saw net cash outflows of $221.8bn while passive funds were in inflow territory to the tune of $17.6bn. Exchange traded funds also saw $178bn in net inflows in 2008, highlighting the gains that passive fund options made during the volatile 2008 period. But outflows do not explain the whole picture.

The FundQuest data goes further in its examination of alpha and questions whether passive is a better option, considering the lack of any strong evidence that active works consistently in all sectors, asset classes and market conditions.

According to the group, in some cases, the answer may be yes. Jane Li, author of Fund-Quest’s report, states: “Our main conclusion is that we should not paint either active or passive investments with a broad stroke. Both types of investments have their strengths and weakness. It depends on the market segments they are in – less efficient, more active.”

Within the UK fund arena, the debate is a little more obscure – many actively managed funds have produced positive alpha but at the same time, many passive funds have done better than active ones. According to Financial Express Analytics, more than half the funds in the large and popular UK all companies sector with relevant three-year track records managed to achieve alpha over the three years to the end of 2008. A total of 169 funds in that category feature a positive alpha score out of 273, the highest alpha being 8.22 per cent by Rensburg’s UK mid-cap growth fund.

The UK all companies sector is also where the vast majority of passive funds reside and their performance has not been without merit in recent times. Trustnet data shows that over the course of 2008 in the UK all companies sector, there were just 65 actively managed funds which outdid the best and lower-costing passive vehicle. So far this year, though, there are just 15 in that same sector which did better than a passive fund.

Thames River Capital multi-manager team’s quarterly research shows another consideration regarding fund selection in these volatile times, finding consistent performers – an increasingly rare objective. This is different from the alpha equation in that many of the top and most experienced managers in the market have all suffered bouts of underperformance.

Of the 12 main sectors researched, encompassing 1,124 funds with a three-year track record up to March 31, just 23 have been top-quartile in each of the last three 12-month periods.

Gary Potter and Rob Burdett note that there is no IMA Europe ex UK, global bond, global emerging markets, global fixed or strategic bond funds achieving this level of consistency. In looking at just those funds that have to achieve above average returns in each of the last three yearly periods, 157 out of 1,124 funds qualify, representing 14 per cent of the duo’s research sample.

Some funds in each of the main categories achieved this level of consistency but the most consistent sector on this basis was Asia ex Japan while the least consistent has been the increasingly popular strategic bond peer group.

However, Burdett says consistency in performance does not always show the whole picture and it can sometimes equate to dull and unexciting growth, meaning alpha is still a vital selection tool. He and Potter believe in a combination approach, looking to hold a large number of alpha managers sufficiently different from one another in order to provide consistency in returns.

Considering the rapidly changing investing environ-ment, advisers are stuck between a rock and a hard place. Do they look for high alpha funds, knowing they could suffer from bouts of underperformance? At a time when investors are wary, this can be unappealing, even if in the long run the decision is the most sound.

Do they opt for low-cost, passive funds? Or is it better to seek out funds which can at least provide consistent top performance, even if it is not always a positive return? Multi-managers would contend that choosing their expertise would circumvent such a dilemma but there is also the option that advisers can select from a combination of the above.

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