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Multi-manager View: Alpha and omega

The recent outperformance by small and medium-cap stocks has not just applied in the UK. In the US, large-cap stocks have risen by 12.2 per cent over 12 months, well below the 27.8 per cent from small caps.

In Europe, the respective gains are 36.6 and 52.6 per cent. There is no reason why this situation should last beyond the influence of the particular factors which are driving it but it is nevertheless influencing fund manager behaviour.

In an environment where the bulk of the market by capitalisation is underperforming, the market has been easy to beat. With success apparently at their fingertips, fund managers have shown new confidence, expressed in a rash of high-performance, higher-charge fund launches. If this really reflects a new and lasting ability to source alpha, it is very good news indeed. However, if what we have seen is managers taking advantage of a capitalisation-based beta stream, the superior returns may not be as long lasting as we would hope.

The problem of finite achievable alpha is being recognised in some parts of the industry, particularly the institutional world, where some managers have closed strategies to new money. Most of the managers that have followed this path have been using some form of quantitative approach where estimates of available information are more readily compiled. Clearly, in the world of open-ended products, closing a fund to new business isn’t on but some attempts have been made to reduce or curtail inflows by soft-closing funds.

Despite the challenges, there is certainly good demand for higher-risk, higher-return funds. Usually backed by an individual with a good record, the assumption is that past returns have been held back by deliberate limiting actions which will not be imposed on the new mandate. But for these returns to be achieved rather than simply targeted, they have to be available and on a consistent basis.

This might seem a strange point to make but it makes sense on consideration. If we believe markets to be reasonably efficient most of the time and we then constrain information flows to ensure no unfair advantage, how can a manager expect to beat the field by enough to justify the alpha fund tag? Take the US market, for example. If news breaks that will impact on Wall Street, somebody will be up and awake to see it. The earnings potential from the market attracts the brightest and best, keeping intellectual competition at the highest level. If the key to outperformance is finding and exploiting information not known to others, how can an investor beat the index consistently and by a substantial amount? Risk can be increased easily but there are no guarantees that returns will rise.

Alpha targets should be set to reflect the characteristics of the market and not the hopes of the fund provider. A multi-manager setting a mandate or an IFA buying a fund must hold in mind not just the chances of a manager doing well but also whether the market can realistically support the targets.

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