by David Scobie
Active management is a difficult game. If it wasn’t, you wouldn’t want to pay much for it. If you do decide to pay up for active management, you want to be able to ascertain that you are receiving real benefit.
Part and parcel of considering active management are the notions of “outperformance”, “value-add” and “excess return”. These concepts inherently refer to a return that is relative to something – a benchmark. Unless we are clear in our minds that the benchmark is a strong point of reference by which to compare the fund manager’s efforts, we are not able to tell whether active management has actually been worthwhile.
When identifying a suitable sector benchmark for a manager (at least for traditional asset classes, we can generally say that a benchmark:
More broadly, in the context of diversified portfolios, it should also be consistent with what has been assumed by the Strategic Asset Allocation analysis.
Let’s make this a bit more practical by taking the case of NZ fixed interest. A benchmark commonly used by fund managers is an index consisting entirely of government bonds. We can assess how this benchmark stands up against the criteria listed above:
1. Does it reflect the investable universe? No, in that mandates typically allow for substantial investment in credit (non-government) securities.
2. Is it broadly indicative of the characteristics of the actual portfolio over the longer term? Not really, as past experience indicates that, although the duration may vary, managers can be expected to invest around 40-60% of portfolios in credit across the
market cycle.
3. Does it resemble the portfolio positioning an active manager might “default” to if it had few high conviction ideas? No, in that actual portfolios will realistically never fully invest in government bonds.
Why does this matter? Where the benchmark consists entirely of government bonds, NZ fixed interest managers are able to generate a return above index by holding higher-yielding credit securities or derivatives, which may be of lower credit quality or less liquid. Over time, in the absence of a sequence of issuer defaults or a prolonged widening of credit spreads, managers can readily accrue an “excess return” - perhaps comprising half or more of the outperformance target.
We see evidence of this in attribution analysis, with the pattern only really challenged by the global financial crisis (an extreme and hopefully rare event).
NZ fixed interest investors who are aware of this context can build it into their active management expectations. However, some investors cannot easily make that interpretation.
There is, therefore, a compelling case for the use of a sector benchmark which includes credit as well as government securities. This approach is consistent with standard benchmarks used within, for instance, the Australian and global fixed interest sectors.
For conventional NZ equity strategies, performance is typically measured against a benchmark which reflects the “beta” of the underlying market, such as the NZX50 Index. For the most part such an approach fulfills the benchmark criteria noted above. In some other cases, strategies adopt a benchmark related to a Cash rate, e.g. the OCR, CPI or Bank Bill index plus a margin.
Mercer does not generally support the use of cash as a benchmark reference for equity portfolios unless the fund manager’s style is truly “absolute return” in focus. To fit this category, the strategy, of which there are very few locally, should be producing returns which are significantly independent of movements in the overall equity market and have the potential to be positive on a year-in year-out basis.
In practice, an absolute return manager can be expected to take very selective stock positions, but also at times hold significant amounts of cash or defensive instruments, and/or short-sell stocks. As there is no requirement for the portfolio to be heavily invested in equities, this gives significant scope to preserve capital during periods of market weakness.
The flexible approach of a highly active manager may be stymied if the strategy needed to maintain an investment profile resembling an equity index. However, if the benchmark in use is tied to cash, one needs to ask whether the strategy is actually absolute return in nature. If the portfolio management style offers a low chance of generating positive returns when equity markets fall, the answer is probably “no”.
Meanwhile, during a sustained bull market, the manager’s “alpha” will look very strong even in the absence of any notable skill. This is a particular problem for the investor if they are being charged under a performance fee arrangement.
A desire to deconstruct as far as possible what is manager “alpha” and what is “beta” is at the heart of the growing trend toward factor analysis, particularly within global equities.
In conclusion, we can say that:
Fund managers who are confident in their ability to deliver strong active returns should be keen to ensure their performance is measured against an appropriately determined benchmark. This allows scope for skill to be clearly demonstrated.
Where a benchmark fails to be reasonably reflective of risk exposures in an actual portfolio, we should question whether what appears to be “value-add” is all that it seems.
Where strategies are managed on a true absolute return basis, assessing performance relative to a cash rate (plus an appropriate margin which reflects the degree of risk being taken) may be justified, in the absence of an ideal alternative.
Where overall market returns are the primary driver of performance, such a benchmark is harder to defend.
When the return outcomes from active management are made transparent, this helps to inform us how much we should pay for it.
*For non-traditional asset classes, such as unlisted real estate and infrastructure or hedge funds, frequently no benchmark index exists that directly reflects the nature of the fund’s assets. In this case, comparisons to peers or a cash-related index may be a point of reference.
**A factor analysis process identifies any consistent style tilts of a manager, such as a bias toward investing in growth, value, small cap or low-volatility stocks. A benchmark can then be selected to reflect the structural elements of a manager’s strategy which can otherwise be obtained via passive (or near passive) management. A comparable example for NZ equities is the arguable case to include an ASX index as part of the benchmark of a manager with ongoing substantial exposure to Australia.
David Scobie is head of consulting at Mercer Investments. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.
David Scobie is Head of Consulting at Mercer Investments. He advises institutional clients on their investment policies, portfolio structures and fund manager selection.
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