Fund managers might do better to focus on generating excess return in credit markets than selecting outperforming stocks
At a glance
• Closet benchmark trading managers face a bleak future.
• Fund managers should be judged by their own stock selection rather than performance relative to an index.
• Portable alpha could be attractive in the current environment.
The S&P 500, the most popular benchmark for US equities, represents the largest and most analysed stocks in the equity universe. Whether it is realistic for fund managers to claim they can consistently beat it is open to question.
Sticking closely to the index and taking small bets on some stocks has certainly been a popular strategy, since it minimises the risk of underperforming too badly and hence the risk of the fund manager getting fired. Such closet indexing approaches, though, scarcely justify their active fees and invariably lead to underperformance over long time periods as the track records of most fund managers show. As the marketplace for cheap index funds and smart beta strategies continues to grow at a rapid pace, fund managers offering such strategies will be facing a bleak future.
It is more justifiable for fund managers to adopt a completely different philosophy. They should be willing to be judged on their own stock selection without measuring risk as a function of overweight or underweight positions against the S&P. “You need to look different from the index to outperform over time. High-active-share managers have the biggest chance, but there will be periods when they underperform,” says Connor Browne, a portfolio manager at Thornburg Investment Management.
“You need to look different from the index to outperform over time. High-active-share managers have the biggest chance, but there will be periods when they underperform”
One way of tackling the challenge is to be able to identify systematic anomalies. For example, GMO is forecasting returns on the S&P 500 of negative 2.3% a year for the next seven years, but it sees a much more positive performance of plus 1.7% a year for what it deems to be high-quality stocks. These are the top 25% of the universe with high and stable profitability and low debt. Beating the S&P 500 should be easy over the next seven years at least, if the portfolio is one of high-quality stocks rather than the S&P 500 universe, argues Catherine LeGraw, a member of GMO’s asset allocation team.
The most foolproof way of beating the S&P 500 consistently, however, may be to give up on stock selection altogether and instead, generate excess returns in the credit markets while rolling over S&P 500 futures, says Roger Lavan of Stone Harbor Investment Partners, a New York-based active manager. Futures are priced to discount cash returns of the appropriate term of the London Interbank Offered Rate (LIBOR). As a result, to match the index returns, an investor would typically roll index future contracts in the desired equity market and place the vast majority of the required investment in cash or debt securities that would be expected to generate returns of about LIBOR.
An equity index future would typically trade at the price of the spot index plus the return available from LIBOR for the period of maturity for the future. Any deviations from this would be quickly rectified by arbitrageurs. If the manager can generate returns above LIBOR, that would result in total returns exceeding the S&P 500 index returns.
Lavan argues that generating excess returns in the credit markets is more achievable than beating the S&P 500 index through overweighting and underweighting stocks within it. “Beating a large-cap equity index such as the S&P 500 consistently over long time periods with low tracking error is almost impossible. But beating LIBOR consistently, we believe, is not only possible, but achievable without taking on excessive credit risks,” he says.
Such portable alpha strategies are well established in the marketplace. Portfolio managers have been porting alpha since financial futures began trading in the early 1980s. “Combining ‘equity beta’ with ‘credit alpha’ gives investors the potential opportunity to take advantage of the longer-term higher average returns expected in the equity markets with the more consistent excess returns available in credit markets,” says Lavan.
What he sees as making portable alpha particularly appealing in the current environment is that the US securitisation markets can provide a ready source of the attractive spreads required for viable strategies. Lavan says that the US marketplace currently offers the most attractive set of opportunities for a number of compelling reasons. The spreads for most US securitised sectors are much wider than elsewhere in the world. The US market is significantly larger, which typically results in superior liquidity and more relative value trading opportunities.
The diverging monetary policy between central banks will probably result in yields rising on floating rate bonds significantly sooner in the US than in the rest of the world. Lavan argues that means investors who do their homework can capture the wide spreads he expects to be available in the US securitised market over the next few years. Moreover, he adds, as the Fed tightens rates, liquidity will remain relatively high as short-duration or floating-rate securitised bonds will be in demand.
For those determined to find strategies outperforming the S&P 500 with low tracking error, perhaps one solution is to avoid having to select outperforming stocks and seek alpha elsewhere.
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