Modern portfolio theory tells us that returns can be traced to two sources – alpha and beta. Almost any level of beta can be achieved cheaply using a combination of a tracker fund, cash and leverage but alpha is more elusive. Over the long term, we would expect the majority of active funds to exhibit a beta of slightly less than 1, which equates to an index-style portfolio less management fees. This corresponds well with the IMA global growth sector which has displayed a broadly stable beta of around 0.85 over the last 13 years. Alpha generation is less stable but a sustained period of outperformance by active managers could be expected to coincide with higher alpha generation. Worryingly, this does not appear to be the case during the latest period of outperformance.
The last four years have seen a gradual but significant increase in the beta of portfolios. Far from becoming more skillful, managers appear to be simply taking a higher degree of market risk with investors’ money. This goes broadly unnoticed while equity markets continue to display an unusual lack of volatility and investors focus on the fantastic returns they have achieved but a market downturn could be a source of severe pain.
For multi-managers, the danger increases as asset allocation and the investment strategy of underlying funds can have a multiplier effect, producing very high degrees of market exposure. We have recently increased the exposure of our funds to managers with lower betas and consistently good alpha generation. In many cases, these managers have been absent from the top of their peer groups over the last few years and have been overlooked by investors. The best examples are Cazenove European, Franklin mutual shares and Lazard emerging markets. Each fund displays a beta of less than 1 and has consistently generated good alpha. This may result in less exciting performance on the way up but should give a degree of protection when markets falter and beta transforms from blessing to curse.
Dan Kemp is fund of funds manager and head of fund research at Williams de Broë.