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S African manager warns of high alpha volatility

South Africa-based multi-manager Investment Solutions is warning investors buying into concentrated high alpha funds to expect volatility through a lack of diversity.<

The firm has launched its first UK Oeic sub-fund, the select UK equity fund, which invests in six high alpha portfolios diversified by manager, style and market cap exposure.

Global business development director Justin Taurog warns that investing in a single portfolio would be inherently risky as managers of these funds typically take strong conviction bets.

He points to the divergence in returns of the two biggest oil stocks – a favourite theme among fund managers – in the third quarter of 2005. BP outperformed Shell by 12.2 per cent while similarly, among the UK’s 10 biggest stocks, pharmaceutical giant AstraZeneca outperformed rival GlaxoSmithKline by 7.3 pre cent over the same period.

Taurog says gaining exposure to high alpha strategies through a blend of high-octane funds will diversify stockpicking risk.

The select UK equity fund holds underlying funds from New Star, ACM Bernstein, Gartmore, GMO, Martin Currie and Mirabaud.

Investment Solutions seeded the portfolio, which aims to outperform the FTSE AllShare index by 2 to 4 per cent a year, with 40m at launch.

Taurog says: “There is a definite appetite for high alpha products but a lot of the funds are very concentrated and it is highly risky to invest with just one manager. That class of funds is better suited to multi-manager.”

Bias beware

The number of funds available to investors has increased dramatically over the past few years. They are also becoming increasingly complicated as products use the full scope of the Ucits 3 directive. In this environment, not only the selection but also the optimum combination of funds is important to generate alpha.

We believe that funds which generate alpha, at different times and in different market conditions, can be combined to generate more consistent alpha at portfolio level. This is achieved by selecting funds which have a low correlation and, when blended together, can produce above-average returns for below-average risk. Identifying appropriate managers and funds requires a combination of quantitative and qualitative research. This is particularly important when you consider the chan- ging effects of style biases on performance.

Let us consider the historical impact of market cap on the universe of funds available to multi-managers. Between the beginning of 1994 and end of 1998, US small caps underperformed UK large caps dramatically. If you had put money into the FTSE 100 in 1994, you would have doubled your money in that time. However, investing in the small-cap index would have returned only 10 per cent. But it is very difficult to predict when certain style biases may outperform or underperform.

Small caps recovered after 1998 and the diff- erence in performance narrowed. During this period, the divergence between growth and value stocks became more important. Recently, size has again become the dominating style.

It is important to recognise that the pattern of returns will be driven partly by exposure to particular style biases so we need to be aware of the biases that managers may have. But we do not tend to make big asset allocation decisions on the basis of style or market cap as the risk of making a wrong asset allocation decision does not outweigh the reward if you make a correct judgement. Nevertheless, if we see that a portfolio manager who has a good long-term record and clearly stated discipline has underperformed, we can explain that underperformance in terms of his style exposures. If the basic investment process remains intact, we can take a view on whether we think we are going to see a return to favour for that particular style or whether we think that the underperformance of that style has reached a point where statistically we would expect to see some level of mean reversion. This would give us conviction to invest in that fund.


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