Factors shaking the alpha world
Active management is under increasing scrutiny as investors become more savvy about how returns are generated, says Paul Amery. This is leading to a debate about alpha equity factors
At a glance
• With the rise of replicable investment factors the concept of alpha needs redefining.
• The terms alpha and beta both derive from the Capital Asset Pricing Model (CAPM), the financial theory introduced in the early 1960s.
• Smart beta strategies are rapidly occupying the unstable middle ground between beta and alpha.
• The pressure to both produce strong performance and cut costs is increasing.
In the old days – let’s say, up until a decade ago – alpha was thought of as the value added by an active fund manager. Any positive difference achieved by the manager with respect to the return on a market capitalisation-weighted index (called ‘beta’) was put down to the manager’s skill.
The search for alpha helped spawn an active management arms race that was highly lucrative for those involved, typified by the hedge fund boom of the 2000s. But times have changed and active management is under pressure as never before. Investors have become more sophisticated in understanding how portfolio returns are generated.
Several analyses, such as a well-publicised study conducted by MSCI on behalf of Norway’s sovereign wealth fund in 2009, have shown that a high proportion of active managers’ past excess returns in equity markets was attributable to exposure to particular market ‘factors’. These include value, small-cap, quality, momentum and low volatility.
Increasingly, exposure to such factors can be purchased via low-cost, index-tracking funds, putting active managers under the spotlight and forcing them to justify their existence and their fees. And with the rise of replicable factors, the concept of alpha needs redefining.
Anyone seeking to pin down alpha still faces a conceptual challenge. The terms beta and alpha both derive from the Capital Asset Pricing Model (CAPM), the financial theory introduced by US academics in the early 1960s. CAPM is still taught at universities and business schools but market practitioners have increasingly called it into question.
James Montier, now a member of the asset allocation team at fund manager GMO, wrote a paper entitled ‘CAPM is CRAP’ when working in 2007 as an economist at investment bank Kleinwort Benson. In his paper, Montier pointed out that several of the ideas underlying CAPM – for example, that higher-volatility stocks should outperform lower-volatility stocks over the long run – are disproved by the empirical evidence. He has not changed his views.
“I don’t believe in the CAPM framework,” says Montier. “Instead, I think the important thing to do is to focus on the drivers of return, whether your strategy is active or passive. You have to understand how you are going to get paid for whatever you are doing.”
Complicating the picture, so-called smart beta strategies are rapidly occupying the unstable middle ground between beta and alpha. Smart beta is a generic term for alternatively weighted index strategies, including those focused on tracking factors.
“Factor-based investing is emerging as a third way of managing money, along with passive management based on market cap-weighted indices and fundamental active management,” says Peter Ferket, chief investment officer for equities at Robeco Asset Management. “But it’s important to remember that factor investing is active, even if it’s index-based.”
According to Marlène Hassine, head of ETF and index research at Lyxor Asset Management, smart beta encompasses a range of approaches, all encroaching into the territory previously occupied by active managers. “Smart beta helps to reduce risk, increase diversification, generate income, to represent the economic footprint of a universe or to enhance returns by capturing systematically some sources of alpha,” she says.
However, Yves Choueifaty, chief executive at asset manager TOBAM, prefers to contrast smart beta with traditional beta. “The standard equity index, weighted according to stocks’ market capitalisation, is biased systematically towards investing in what is expensive. It overweights large-caps and individual sectors and styles,” says Choueifaty.
“I’m sure that in the coming few years we’ll realise that the true added value of smart beta is not in delivering alpha. Instead, agnostic smart beta strategies – those claiming not to have any special insight – will help show that the traditional benchmark generates negative alpha.”
By ‘agnostic’ smart beta strategies, Choueifaty says he means indices based on equal weighting, equal risk contribution or maximum diversification methodologies, the latter of which is TOBAM’s speciality. All these index approaches have no explicit or implicit return expectations. He argues that factor indices are a version of active management.
Faced with the prospect of smart beta products promising to deliver excess returns at a fraction of the traditional cost of active portfolios, active managers are under increasing pressure to define what they do.
“The role of the traditional stock-picker is becoming more difficult. But there are still ways you can add value. Some active managers will thrive on the ability to spot trends, others willwin by having a different perspective”
For Ken Volpert, European head of investments at fund manager Vanguard, alpha does exist but it needs to be offered cheaply. Although an indexing giant, Vanguard allocates a third of its assets under management to external active managers. “We’ve found that around 15-25% of active managers are able to outperform their style-adjusted benchmark, in other words after adjusting for factor tilts, over 10-20 year periods. That’s good. The problem is that alpha is variable and you need to get it at a good price,” he says.
According to Robeco’s Ferket, the future of active asset management is in more concentrated portfolios. “The way forward for active management is in high-conviction stock selection, based on in-depth fundamental analysis of individual companies, and in portfolios that are non-benchmark-oriented and highly concentrated,” he says.
GMO’s Montier has a different take. “The more factors are taken up, the more micro-efficient the market has become,” says Montier. “In other words, the role of the traditional stock-picker is becoming more difficult. But there are still ways you can add value. Some active managers will thrive on the ability to spot trends, others will win by having a different perspective. There’s also still little evidence the market is becoming macro-efficient. We still get events like the tech bubble, the global financial crisis and the euro-zone crisis.”
As the trend towards factor investing accelerates there is pressure on market participants to agree on definitions of factors. “There’s a need for a framework to define factors,” says Lyxor’s Hassine. “For a factor to have validity it needs to have some theoretical justification, as well as having empirical backing. Data mining alone is insufficient.”
“The standardisation of factors would be a positive development,” argues Christian Hille, head of multi-asset at Deutsche Asset Management. “Even for a widely used factor like value you can have a variety of definitions.”
But such a standardisation push could help throw up opportunities for active managers, says Ian Heslop, head of global equities at Old Mutual Global Investors. “Standard factors or styles, such as those available through indices and ETFs, may have an Achilles’ heel,” he says.
“Value, quality and momentum, for example, can have very large drawdowns. Value, for example, tends to work best when the overall market goes up. Our approach is to dynamically weight between different factors, as well as redefining the underlying factor styles.”
Gideon Smith, European chief investment officer at AXA Rosenberg, also sees new possibilities for alpha amidst the factor boom. “There are three ways active managers can add value by reference to a portfolio of factors,” says Smith.
“The first is to use better factor definitions. The second is to time your factor exposure and to manage the risks associated with factors at particular points in their individual performance cycles.
“The third is to manage better the decisions associated with turnover, trading costs and liquidity that go with any factor index. An active investor has to think about the realities associated with managing money.”
Whatever alpha-seeking managers’ future role turns out to be, there is general agreement on one topic from participants on both sides of the active/passive debate: the pressure to produce strong performance and cut costs is increasing.
“Smart beta is pushing the bar ever higher for active managers,” says Hassine.