We are in a low return environment. We have had a good run in equity markets, helped by the ECB, and the US Fed; reasonable valuations; and investors’ generally underweight positions and it may continue for a while.
But reality will come back as the markets figure out that sorting out the European problems is a long game, requiring either devaluation or default. With developed market interest rates below 1 per cent, total returns are likely to struggle to be much above inflation, especially after tax.
What to do? I have previously beaten the diversification drum, letting the portfolio collect a balance of risk premiums from passive market exposures rather than relying on equities, which dominate the risk of most multi-asset portfolios.
Diversification should be complemented by a highly critical examination of value for money from the active managers in which a portfolio is invested. If a manager charges an annual management fee of 1.5 per cent and an ETF costs 0.2 per cent, then the extra 1.3 per cent cost is a big number in the current low return environment.
How does an investor get value for money into the portfolio?
First, by recognising that a portfolio of diversified and risk-balanced sources of equity, bond, inflation-linked, commodity and credit beta is likely to provide attractive long-term, relatively stable returns and that these can be bought cheaply. Second, by recognising that manager alpha is scarce, not easy to identify and that even for high alpha managers, you are often paying for a large dose of market beta. So manager selection is critical and a portfolio should only include active managers where an investor has a high conviction of finding alpha.
We analysed the universe of IMA UK All Companies managers over the last three years by running regressions against weekly returns. Of the 255 managers in this universe, only 52 generated alpha over 1.5 per cent, the typical AMC.
The top 10 managers (by total return) produced between 20.4 per cent and 5.7 per cent annualised alpha. Headline AMCs were between 0.65 per cent and 1.75 per cent, so anyone buying a top decile fund would have felt they had got value for money.
The 10th ranked manager, with alpha of 5.7 per cent, had an AMC of 1.5 per cent. Market beta could have been bought for 0.2 per cent. So, if an investor had picked this manager, they would have paid 1.3 per cent for 5.7 per cent of alpha.
The question is whether the ratio of alpha to AMC is sufficient to compensate the investor for the risk that the manager underperforms over the next three years – as 56 per cent of this manager’s returns came from market beta.
Among the top 10 managers, the top-ranked manager generated alpha of 20.4 per cent. Market beta accounted for just 16 per cent of total return.
The second-ranked manager produced alpha of 15.2 per cent. Obviously worse?
If we look at the volatility of the alpha, the picture changes. Manager number one has alpha volatility of 14.6 per cent versus the second manager’s alpha volatility of 7.6 per cent. So which is better, a much more predictable, but lower alpha or a highly volatile, higher alpha? Lower, but more certain, alpha is likely to be better value for money.
Michiel Timmerman is managing director and chief investment officer at Ignis Advisors