Top 400: New perspective on equity strategies
Alternative investments have enjoyed a meteoric rise as institutional investors seek to diversify their assets in a low-return environment. As some of these investment strategies have become more established and as complexity has increased in many traditional strategies, it is reasonable to ask just how ‘alternative’ are alternatives?
The traditional division of asset classes is becoming less relevant and can lead to sub-optimal investment strategies. While portfolios are traditionally divided into equity, fixed income and alternatives, we argue that focusing instead on the underlying beliefs and drivers of return is a better way to approach portfolio construction.
Simply put, investors expect to earn a return above a risk-free rate for taking on risk – the risk premium. For example, the equity risk premium (ERP)– or credit risk premium – compensates investors for bearing different types of uncertainty around future cash flow. There is an illiquidity premium compensating investors for locking up their capital for longer periods of time. Also important is ‘skill’ premium – this is the concept that some return (positive or negative) is the result of active manager skill. This skill should be evident above any systematic style or factor premia that can be relatively easily captured at low cost, such as a value premium or a trend-following premium. These latter factors are often referred to as smart beta.
Investors have traditionally grouped equity strategies into passive and active long-only equity, with other forms of ERP, such as long-short equity hedge funds and private equity coming under alternatives. However, equity strategies can be classified differently, providing a more obvious link with their risk premia (see figure 1). This is a more helpful way of considering the opportunity set as it enables investors to more easily link their goals with the return drivers and allocations of their portfolio.
Having decided how much capital to allocate to the ERP, most investors jump straight to implementation. As a result, they can end up with the majority of their equity assets in passively managed (market-cap weighted) long-only equity and traditional long-only active management that is also market-cap benchmarked. Some may have a small allocation to alternatives, giving them exposure to long-short equity, private equity and possibly some multi-strategy hedge funds.
This fairly typical asset allocation might well imply a belief in the ERP (they are long equity); that markets are not completely efficient (they use active management); and that deviation from a benchmark index should be constrained to limit underperformance (they measure risk relative to the benchmark). Furthermore, it implies that an illiquidity premium is available (small allocation to alternatives) and that limited governance means the structure should be kept simple (relatively few managers).
At first glance, these seem to be reasonable beliefs. However, the resulting portfolio is dominated by ERP, and the impact of skill and illiquidity is limited. So one might challenge them as follows:
• Is it not possible to improve on bulk beta (market-cap weighted) with smart beta?
• If there is a belief in alpha then perhaps alpha is easier to find and exploit in less efficient markets or with less constrained mandates;
• Can we not exploit the illiquidity premium on a de-risking journey given the likely timescale and the existence of a secondary market?
• Does the wide range of solutions available on the market today not mean that governance can be treated as a variable rather than a constraint?
In doing so, investors can materially alter their perspective and approach to portfolio construction, improving the efficiency of their equity-driven and total-portfolio return. Also, it focuses investors on the ‘mission’, and the investment objectives and beliefs. This approach has the greatest impact on long-term results.
By focusing on investment beliefs, there are often meaningful changes to the desired risk premia and portfolio construction process. We demonstrate this by considering the skill premium.
Investors typically access the skill premium by using traditional long-only active managers that take active positions around a market-cap benchmark in a tightly controlled way. But if there is a genuine belief in skill, the starting point should be different and asset owners should use mandates.
• that concentrate on a manager’s best ideas and are significantly different from market consensus (high active share);
• that allow managers a greater degree of freedom to take long-term views without constant short-term comparisons to benchmarks; to give managers the freedom to put capital at risk when they have high-conviction ideas; and to take advantage of an activist premium;
• where fees are typically a lower proportion of potential alpha.
With this new perspective, investors can construct equity portfolios that increase the expected returns from the skill premium by allocating more to private equity (subject to liquidity constraints) and long-short equity (subject to risk tolerances). Further capital can be allocated to very concentrated or high-active-share long only. The portfolio can keep a liquidity buffer and access ERP and style premia cheaply using bulk beta and smart beta, while also providing a portfolio construction tool to complement the active managers. The resulting portfolio looks significantly different from the starting point and can significantly improve expected portfolio efficiency (figure 2).
Traditional asset class frameworks and approaches to portfolio construction can undermine the diversification benefits and returns of a portfolio, primarily through a lack of focus on investment mission and beliefs. A clearer focus on these aspects, together with an understanding of the underlying drivers of returns, can lead to superior portfolio construction and efficiency gains.
Stuart Gray is senior investment consultant at Towers Watson