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Multi-management View: Alpha and omega

The development of higher-performance target funds is a reaction to a number of developments in the fund management industry. These include competition from hedge funds, recognition of the need to price alpha and beta differently and an attempt to increase margins in an industry where cost control has been problematical. But these new funds are not necessarily a win for investors.

At the heart of the issue is the question of whether there is sufficient alpha available to meet the promise. To generate alpha, a fund manager has to be able to find information inefficiencies that have yet to be reflected in values. The consistent availability of these inefficiencies varies across markets. At one end of the scale are areas such as emerging markets where lack of research and a restricted number of potential investors provide the potential for unexploited value. Currencies are another sector of opportunity but for different reasons. Participants in this market can have unrelated objectives to gain maximisation.

But not all markets are so obliging. The US equity market is subject to massive scrutiny. How can a manager be expected to have a consistent edge in this environment? Government securities are an overanalysed sector with only one available call – on the path of interest rates. Taking on big bets in these markets adds risk but not necessarily return.

Just as important is capacity. All investment approaches have a ceiling on the amount of value they can add. Managers that limit their area of focus, say, to a style bet such as value or growth, will have less capacity than those which target the entire market. In small-cap stocks, the problem is one of cost and liquidity. Finding an attractive stock is one thing but getting a worthwhile holding at an attractive price is another. Compounding this is the problem that the value of any approach is lost over time as others discover and exploit it.

Capacity limits and loss of advantage help explain why managers can lose momentum as funds under management grow. The question to ask is whether the alpha is there to be exploited. If capacity is constrained, the risk is that the fund can only provide returns by reducing potential for existing investors.

The final part of the equation is cost. There is an old adage that the best way to improve returns and cut risks is to cut costs. Costs have an impact in several ways. The attraction of applying a high annual charge is clear but, from the performance perspective, it is a case of the manager raising the bar against themselves. Turnover costs are also important. Here, the focus should not be on commission, which is transparent and manageable, but on market impact. This manifests itself in the premium required to acquire a large position or the discount taken on the price to sell one, and also in the time taken to complete an order in active markets where the price is moving away. If costs and charges combine to give a total expense ratio of 3 per cent, then the fund has to outperform by that amount just to break even. Add to this the outperformance promise and we see relative return targets which can seem heroic.

Managers can be tempted to augment returns by making bets on beta. This is a significant departure and can add volatility. It is when, instead of identifying the best opportunities within a benchmark, the manager bets against it. In some cases, the decision is clear, for example, switching assets into cash in expectation of market weakness or a manager of a domestic portfolio adding non-UK assets. But in other cases, it is less obvious. For example, a keen stockpicker managing a UK equity fund that is overweight in small caps may find that the small-company effect dwarfs the stock returns.

The reality of alpha is that it is a zero sum game in equity markets. For every manager that outperforms, another must fail. John Kelly is head of client investment at Abbey


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