Joseph Mariathasan: Strategy selection vs manager selection
Active managers are on the defensive against the massive growth of passive exchange-traded funds, and the battle lines may be most fraught in global equities.
The global equity universe is massive. There are 30,000 stocks to potentially invest in. It is beyond human capabilities to cover the complete universe using a fundamental approach, but global equity markets can be approached in numerous ways – through passive indexation, enhanced index and smart beta (is there a difference?), quantitative systematic strategies, broad fundamental active strategies, focused active strategies, market neutral hedge funds, 130/30, and so on.
What are the trade-offs of costs versus excess returns for these strategies? Who takes the benefits – fund managers or the owners of capital? What should be an equitable fee structure?
These questions are not only important for investors, but are also critical for fund managers as the answers ultimately determine their business strategy. For the largest multi-strategy firms they may be less relevant, as they can cover most – if not all – of the options. They justify this on the grounds that investors are ultimately trying to find solutions for different needs. Smaller boutiques focus on specialist areas. Mid-size firms, however, are facing challenges: the recent merger of Henderson and Janus reflects the pressures on these kinds of companies to cut costs as they face increasing challenges from lower-cost alternatives.
Putting a framework to the range of options in the global equity space is a useful exercise not only in educating the investor, but also in helping to determine where the best trade-offs are likely to be between fees and potential returns.
The simplest and cheapest approach to global equity investment is clearly via passive indices. Some consultants see them as particularly useful if exposures are undertaken synthetically via derivatives, as this allows better balance sheet management for pension funds enabling them to gain leveraged exposure to equities.
Slightly more expensive would be smart beta products, which give tilts to factors that have rewarded for long periods of time. They are also providing a threat to many active managers who have been effectively just packaging up smart beta approaches and, as a result, many of the traditional diversified global equity portfolios are starting to shrink.
Moving up the complexity scale and fees from smart beta would be quantitative managers, and there is a grey area between the two. Many quant managers have been running factor-based strategies for 20-30 years and been doing so relatively successfully. Large pension funds investing a couple of hundred million euros or more can hire quant managers for 25-30 basis points a year, while smart beta costs would be 15-20bps, with the more basic end at 10bps. Consultants argue that the extra sophistication you are getting from a quant approach over smart beta is quite significant. In return terms, you should be very well compensated for that extra 10bps of fees.
A smart beta strategy would have 1,000 stocks, a quant manager would have 200, while a fundamental manager would have something between 30 and 80 depending on strategy. With each step you are reducing the number of stocks, increasing the tracking error and potentially increasing the return. Active managers would charge between 40-60bps for a developed global equity strategy. Adding emerging markets would add 5-10bps on top for all strategies.
Beyond this lies the hedge fund world. A lot of firms are reacting to the new reality of the industry – essentially a lower cost base in a lower return environment. Fees in the long-only space have roughly halved for active managers over the past decade or so, but hedge funds have not reacted to or felt so much pressure to readjust. Hedge funds still justify very high fees with the promise of very high returns.
That is coming under pressure and there has been a move out of hedge funds by a number of large asset owners. Investors need a very compelling reason to pay 2 and 20 to a hedge fund where you may end up paying 4% in fees, 10 times higher than a conventional manager.
So where lies the best trade-off between fees and potential returns? It is worth taking a view on relative valuations. Certain strategies have done well in recent times but is there much point in trying to get a good deal with products that are close to capacity after a very strong run?
In contrast, strategies that are out of favour – such as value strategies that have underperformed recently – may be worth considering. The managers have probably lost assets, but the style works (although it tends to go out of favour for long periods before coming back). For institutional investors, picking the right approach may be more important than picking the right managers.