Investment managers do not always stick to their stated investment philosophies, and there is evidence that many are managing money in similar ways.
This is according to the latest Alexander Forbes Manager Watch survey of retirement fund portfolios.
The survey notes with that this “herding”, particularly among managers of equity funds, means that many managers are vulnerable to similar market trends. Therefore, even if you, as an investor, have spread your investments across different managers, you could find your investments performing the same way when a trend, such as the commodity cycle, affects performance.
The survey reveals how managers of retirement fund portfolios have performed relative to their peers and their benchmarks. The analysis of their performance is relevant to anyone who is choosing more than one asset manager to manage their long-term investments.
The survey includes 46 investment managers and 335 retirement funds with assets under management of R4.94 trillion, and covers 14 different investment strategies.
The survey begins with a big warning that performance alone will not help you to identify a skilful manager.
Performance data contains too much “noise” – factors beyond a manager’s control that “contaminate” the data; so it can be dangerous to attribute good returns to skill, the survey says.
And instead of simply considering who is at the top of the performance tables, the survey says you should be concerned about whether you have a mix of managers that complement each other, rather than do the same thing.
Typically, the trustees of a retirement fund should determine what they need the fund’s investments to do to meet the fund’s liabilities. This is called the desired outcome, the survey says. You, as an individual investor, should determine your desired outcome.
Then your fund’s trustees, or you, should choose an appropriate asset allocation and set benchmarks against which the performance of the investments in each asset class can be measured.
The biggest allocation of a retirement fund, or a long-term investor, is likely to be to equities, because this asset class is most likely to produce inflation-beating returns. If you are investing for the long term, you need to accept the risk inherent in investing in equities.
The survey says the simplest way to benefit from equity returns is to invest in a passive investment – in other words, a fund that tracks an index. In this way, you earn what is known as beta.
However, if you use an active fund manager, you can potentially improve your returns or reduce your investment risk, or preferably both, the survey says.
When a manager enhances the return you can earn from a market, it is said to generate alpha.
The Alexander Forbes Manager Watch survey says a manager has to invest differently from the benchmark to earn alpha. Although this has the potential to compromise beta, it should result in the manager earning a higher return than an index-tracking investment.
Investment managers use different investment styles to generate alpha. Alexander Forbes says that different equity investment styles are rewarded over different periods, so a manager is likely to have periods when it either out-performs or under-performs the market.
A blend of different managers should reduce, rather than amplify, investment risk and ensure that your returns are consistently above the market throughout different market cycles, the survey says.
According to the survey, over the past few years, the value style has under-performed the market, while the momentum style has out-performed market indices (see “Definitions”, below).
Over the 2014 calendar year, the momentum, minimum volatility and quality styles were rewarded, while the value and deep value styles continued to struggle, the survey says.
Value, or valuation-based, and momentum are the most prevalent investment styles among South African fund managers, and the “herding” is particularly towards the value and contrarian styles, the survey says.
Alexander Forbes says the popularity of value and contrarian investing has resulted in many managers diving into resource shares and eschewing shares that have performed well, such as Naspers, Aspen and MTN.
The survey notes that, overall, equity managers failed to out-perform their benchmarks in 2014, despite the markets presenting opportunities for them to do so. In 2014, only 15 equity managers out of 50 (that each manage a group of similar portfolios) beat their benchmarks.
It says the under-performance of deep-value managers is understandable, because this style has not been rewarded by the market for some time.
The survey says very few managers of benchmark-cognisant portfolios out-performed their benchmarks over the year to the end of 2014 (only two out of 19 managers of groups of similar portfolios), while only 11 out of 28 funds managed by benchmark-agnostic managers out-performed their benchmarks.
The survey notes that there was greater diversity of performance among benchmark-agnostic managers, and these managers have a better chance of protecting you from a downturn in the market than a manager that follows the benchmark closely and typically has more shares.
In comments on the performance of multi-asset portfolios that can invest offshore, the survey notes that most managers were defensively positioned, with too much invested in cash. This, together with their stock selection, impacted negatively on their performance.
DEFINITIONS
A benchmark is the yardstick against which an investment manager’s return is assessed and measured. Benchmarks are usually stock market indices, or the average returns produced by the peers of a fund or portfolio, or an inflation rate.
Investment styles
Momentum: A manager following this style will look for shares that are doing well and whose share price is trending upwards, in the belief that the impetus will be enough to drive further price increases. Shares whose prices are trending down will be sold.
Growth: A growth manager looks for companies that have a good potential to grow their earnings at a higher rate than the average for the market sector.
Quality: These managers look for the shares of companies that are profitable and have consistently good earnings and robust balance sheets.
Minimum volatility: These managers look for quality shares that are not subject to major price fluctuations, to deliver a smooth pattern of returns. These shares are usually in what are known as defensive sectors that are relatively immune to economic cycles. They typically have high dividend yields.
Value, or valuation-based: These managers look for shares or securities that are priced below the value of the company, as determined by the manager, in the belief that the share price will return to fair value.
Deep value: These managers follow the same principles as value managers but look for the cheapest shares and hold them for long periods.
Contrarian: A contrarian manager goes against trends in the market, buying assets that are performing poorly and selling when they perform well.
Portfolio construction
The Alexander Forbes Manager Watch survey identifies three broad ways in which managers construct portfolios:
* Enhanced index strategy: These portfolios take small positions relative to an index – that is, the portfolio buys more or fewer shares than their weighting in the index. The portfolio assumes a level of risk similar to the benchmark, and it will out- or under-perform the index by small amounts – 0.5 to one percentage point.
* Non-benchmark-cognisant, or benchmark-agnostic: These portfolios are constructed with little or no reference to how shares are weighted in the benchmark, or they take large positions relative to the benchmark. Some may have a higher level of risk than the benchmark. These portfolios may invest in shares that are not even in the benchmark. They may out- or under-perform the benchmark for a long time. Investors need a high tolerance for long periods of poor performance.
* Benchmark-cognisant: These portfolios are similar to non-benchmark-cognisant portfolios, but they consider and carefully balance the risks they take relative to the benchmark. In other words, they actively manage the trade-off between the returns they can earn from the market and the returns they can earn above the market.
DON’T TRY TO PREDICT WINNERS
Investment managers follow many different investment philosophies, and the choice of philosophy is less important than the manager’s translating that philosophy into its portfolio construction, applying it consistently and understanding how it results in performance, Alexander Forbes says.
Trying to predict which manager will out-perform in which period is a fruitless exercise, the Alexander Forbes Manager Watch survey says.
However, if you blend managers with different types of skill, you can reduce the uncertainty and maximise the periods over which your investments will generate out-performance, the survey says.
The challenge is that you need to blend styles that complement each other, rather than double up on the same style, and to do that, your retirement fund’s trustees, you or your financial adviser needs to identify managers that do what they profess to do when managing your money. In particular, the survey says you need to understand:
* How a manager’s investment philosophy and process (how it chooses shares) provide opportunities for it to identify and capture alpha;
* Whether a manager’s portfolios do, in fact, reflect its investment philosophy; and
* Whether the risks that a manager takes are adequately rewarded.
Your analysis should examine a manager and its portfolios over time.
The Alexander Forbes Manager Watch survey uses various measures to determine whether managers adhere to their philosophies, the risks they take, the timing of their transactions and their conviction. A manager with conviction will hold fewer shares than one that does not.
Conviction can be measured by looking at the number of holdings in a portfolio, the concentration of those securities (the weightings of the shares in the portfolio) and the active share, which measures how an equity portfolio’s holdings differ from the constituents of its index benchmark.
Trevino Ramsamy, the head of investment surveys at Alexander Forbes, says the survey’s analyses highlight how some managers are not sticking to the investment style they say they follow. For example, a manager that claims to be a high-conviction manager, running a concentrated portfolio, should have a lower number of shares than the manager of the average equity fund. However, there are managers who claim to be high conviction but have over 100 shares in their portfolios, he says.
The Alexander Forbes survey focuses on individual managers within each investment strategy. It includes a survey of funds that are multi-managed. However, in an article entitled “The value of investment performance surveys”, Ramsamy and Anne Cabot-Alletzhauser, the head of research at Alexander Forbes, note that “what is pointedly absent from any performance analysis is how the multiple-manager portfolios that trustees and consultants themselves structure perform against similarly mandated blends”.
Ramsamy and Cabot-Alletzhauser say this would give you a true like-with-like comparison of pension funds.
MANAGERS THAT FOLLOW AN INDEX BENCHMARK CLOSELY CAN MAKE THE WRONG CALLS
If you focus only on how an investment manager has performed relative to an index benchmark, you will ignore other critical issues, particularly the risk of losing money, a new boutique asset manager says.
Lonwabo Maqubela, a portfolio manager at Perpetua Investment Managers, says although the performance of an investment should be measured against a benchmark, you should consider whether an index benchmark – in particular, the two popular indices for South African equity managers, the FTSE/JSE Shareholder Weighted Index and the FTSE/JSE All Share Index (Alsi) – are suitable measures of your investment goals.
Perpetua Investment Managers was founded by Delphine Govender, who was one of Allan Gray’s equity fund managers.
Maqubela says an obsession with out-performing an index benchmark can affect an investment manager’s behaviour in ways that favour the manager’s business and not long-term returns for investors.
Most managers fear losing investment business if they produce a return below the benchmark over any period. As a result, Maqubela says, several investment managers use the benchmark as their default position when they construct their portfolios; they then, to varying degrees, go either overweight or underweight in individual shares, depending on their view on a specific share, without their portfolios straying very far from the share’s weighting in the index.
This approach results in the portfolios retaining their exposure to shares with large weightings in an index even when the managers believe the shares are overvalued or expensive, Maqubela says. This poses some real risks in a highly concentrated market such as South Africa’s.
Maqubela cites the example of Anglo American, which had the largest weighting in the Alsi (13.6 percent) at the end of 2007, when the index was at its previous peak. It is likely that this share would have been one of the largest holdings in a benchmark-cognisant investment manager’s portfolio, even if the holding was underweight relative to the Alsi.
At the end of 2014, Anglo American’s weighting in the Alsi was 4.3 percent. From 2007 to 2014, Anglo American under-performed the market by more than 40 percent, and the total return for the share was minus 48 percent. Therefore, it was an incorrect decision to own any Anglo American shares over this seven-year period, he says.
Naspers had a benchmark weighting of 1.4 percent at the end of 2007. At the end of 2014, it was the second-largest share in the Alsi, with a weighting of 8.3 percent. As the change in its weighting indicates, Naspers increased in value by more than 830 percent in absolute terms, and the share out-performed the Alsi by more than seven times between 2007 and 2014.
Maqubela says, currently, Naspers is one of the five largest shares in many investment managers’ portfolios, partly because of its large weighting in the Alsi, whereas Perpetua would argue that the best time for managers to have included Naspers as one of their five largest shares was about seven years ago, before the share price increased.
These examples show that investing according to a benchmark can often result in a manager taking the wrong positions at the wrong time, particularly when markets are at extreme levels, such as at the end of 2007 and 2014, Maqubela says.
MANAGERS’ FEES HAVE COME DOWN
The Alexander Forbes Manager Watch survey of retirement fund managers notes that, overall, managers reduced their fees over the past year.
It says more managers charge fees based on out-performing a benchmark or hurdle than managers that charge “flat fees”, which are a percentage of the assets under management.
The survey notes that the fees for portfolios managed according to a South African balanced mandate (investing across all asset classes in local markets only) increased by more than 10 percent, whereas the fees for global balanced mandates (investing across all asset classes in local and offshore markets) decreased.
It also notes that segregated portfolios (individual funds that are managed according to specific investment mandates) have become cheaper than pooled portfolios (the assets of different funds are pooled and managed according to the same mandate).
Trevino Ramsamy, the head of investment surveys at Alexander Forbes, says this seems counter-intuitive, but some of the reasons are that pooled portfolios are priced daily and their compliance, regulatory and reporting costs have increased.