When choosing active managers it is very important to distinguish between truly active managers and closet index tracker (active) managers. For example, any active manager that worries about tracking error (the extent to which their portfolio’s returns deviate from the benchmark) runs the risk of being a closet index tracker. Active managers are paid a fee to outperform a benchmark, not to hug it. Consequently, active managers who hold concentrated portfolios are more interesting than overly diversified managers.
It is possible in principle to construct a portfolio comprising of wholly passive products reflecting a particular asset allocation view. Given the importance of asset allocation in terms of investment performance and the relative cost savings of this approach this is not too bad an idea! However, there are areas where the skill and judgement of active managers is necessary. Passive investment strategies only work well when a specific strategy can be codified i.e. reduced to a set of rules that can be implemented consistently. Unfortunately there are some areas that don’t lend themselves to this. Asset allocation is one of them! This is where we believe active managers can earn their fees.
In conclusion, a multi-asset multi-manager’s role is to set the asset allocation for a desired return target and select the best way to implement this view. Where exposure to a particular asset class or investment theme is required looking for a passive alternative is a good starting point. They provide a consistent way to express an asset class or investment strategy view. However, active managers can add outperformance and diversification to this mix and so they should be viewed as a complement. The problem is thus not which approach is better than the other - it is rather one of how much of each an investor should have.
By redefining the concept of active versus passive, institutional investors can have a multi-strategy effect within their investment portfolio by implementing a core-satellite approach. Core strategies are typically those that are well diversified and provide broad exposure to an asset class, while satellite strategies complement a core strategy by providing the opportunity to generate alpha.
Traditional beta is typically best used as a core approach because it results in the lowest tracking error and provides the broadest exposure to an asset class. Conversely, concentrated active is used exclusively as a satellite approach because it has the highest amount of tracking error and typically results in the highest alpha as well. Therefore, a combination of the two should result in a market-like return from the traditional beta strategy complemented by the alpha generated by the concentrated active strategy. Smart beta and diversified active strategies can serve as either core or satellite approaches, depending upon the asset class; however, institutional investors should refrain from using traditional beta strategies as a satellite approach or concentrated active strategies as a core approach. This is because traditional beta strategies do not generate the alpha required of a satellite approach and concentrated active strategies do not provide broad exposure to an asset class because they result in too much tracking error.
Rather than broadly defining active and passive, investors would be better served by differentiating diversified from concentrated within the actively managed portion of their portfolio and traditional beta from smart beta within the passive portion. Doing so should allow investors to better understand the risk and return expectations of each strategy, as defined by tracking error and alpha, thereby allowing these different strategies to be used as complementary solutions within an investment portfolio. This should add value to the portfolio whilst minimising volatility.
Traditionally, investors have appointed investment managers to (actively) manage their exposure to asset classes - their asset allocation - and individual assets within each asset class - asset selection. Fund managers charge a fee for their service of constructing portfolios for their investors - either at the asset class or individual asset level, or both. In return for this they try to outperform their benchmarks. In the case of asset selection it would be something like the FTSE, MSCI or S&P500. They do this by identifying assets (shares in this case) that will outperform the combination of assets that make up the benchmark. Fund managers’ value proposition is that their skill in selecting assets (or asset classes) produces sufficient out-performance against the relevant benchmark to justify their fee.
Passive products differ from active products in two key ways. Firstly, individual assets are selected on a mechanical basis; and secondly their fees are significantly lower. The first generation of passive products was designed to replicate the returns of benchmarks such as the aforementioned. The range of these products has been broadened to include index tracking funds covering specialised indices that concentrate on a particular sector, e.g. commodities or technology, etc.
Other, more recent versions try to improve on this in systematic (i.e. mechanical) ways. Some use different measures to market capitalisation (the way the FTSE, etc., is constructed) to build their portfolios. The latest evolution in the passive space includes the so-called ‘Smart Beta’ products. They use pre-determined (i.e. mechanical) investment strategies to give investors consistent exposure to a particular investment style or outcome. Examples include value and momentum style portfolios and risk managed portfolios such as the minimum volatility (min-vol) product. These products all construct their portfolios using a fixed methodology or set of rules.
The ‘style’ funds such as value and momentum products systematically identify the presence of these ‘factors’ and construct portfolios of equities which embody them. In the case of the min-vol portfolios, they are constructed in such a way as to minimise the volatility of the returns of the portfolio using average historical returns and variance/co-variance matrices. As with all passive products the fees are low as the ‘recipe’ is fixed and the portfolio manager merely oversees its application.
Passive products have been around for a while in their various guises but it is only recently that they are getting more widely used in the many more markets. Why the delay? We believe that most investors tend to view them as direct alternatives, or substitutes, to the traditional active funds. If it is framed in this way, the debate immediately becomes one of ‘either/or’ - in other words: which approach is better than the other?
Comparisons are most often then made between the lower fees of the passive funds vs. the (often temporary) out-performance of the active managers. Somehow the idea of buying consistently average performance is not that exciting - even when it’s very cheap! However, as customers become more familiar with the concept of passive products and their relative advantages they are beginning to choose them more often. The relatively low returns environment offshore has also pushed investors there into using the cheaper passive investments to save on the negative impact of costs on their (already low) returns.
A more productive perspective is to view these two investment approaches as complementary to other - they can both play different, but equally important, roles in a portfolio. Passive products allow us to get very precisely targeted, consistent exposures to asset classes and investment strategies at a relatively cheap price.
We value this highly, given the importance of asset allocation in our investment process. The more recent developments in this field, such as the Smart-Beta products, allow us to get consistent exposure to investment strategies that were previously only available via active managers (e.g. value, momentum or high yielding equities). Furthermore we had to hope that active managers would implement these strategies consistently - in other words, there was no style drift. Now we can be certain of this outcome if we go the Smart-Beta route.
To be continued…
One of the most confusing parts to funds can be the charges you pay and who you are paying that money to. There is also the issue that not all funds or advisers charge the same. Obviously though, whatever the cost these charges are going to affect the overall performance of the fund so they must be accounted for when calculating what your risk/reward ratio is.
When you are planning your future, it is vital that you work out how much risk you are prepared to take on and when you are going to need access to the money you have invested. Remember, if you cannot afford to lose anything then you should not invest at all.
The most important thing for the new investor is preservation of capital and not, necessarily, increase in capital. The best way to do this is by diversification. The easiest way to understand this is if you have shares in ten companies and one of them loses a lot of money then you will feel the loss heavily. If you have the same amount in each company then you will, naturally, lose ten percent. If you had access to ten times the amount of companies the risk is massively reduced. However, you will have had to pay a small fortune in stockbroker fees thus making the point of diversification a bit meaningless.
Most of this article will relate to Unit Trusts. However, to that people can see the difference:
- Exchange Traded Funds are listed on a stock exchange and investors buy or sell them in the same way as they would shares. They are very good for people who like liquidity.
These days, it is vital that investors know what they are doing. Markets are volatile and it is possible to lose heavily in a very short space of time. Just look what happened to gold recently. No longer can you just buy a bunch of shares or stocks and hope they will grow and give a good, steady increase on capital.
As regular readers of this column know, I have been banging the drum about diversification of a portfolio for many years now and maintaining low volatility and liquidity in a fund are also very important. By having access to multi-asset, multi-managed funds you will protect yourself from placing all your eggs in one basket and thus, potentially, incurring losses due to one particular asset class retracing any previous growth.
Before I go on, please remember that I am only referring to offshore funds. Also, please ensure that before investing you are not liable to pay anything on your portfolio due to your own country’s tax laws. Finally, if you cannot afford to lose money then do not invest at all.
For those that have not invested in funds before there is a huge amount of information to digest. You need to know what they are, why they should be part of a portfolio, how to choose a fund that reflects your risk/reward ratio and the costs of having a fund.
The first thing to remember is that funds are for the long term. If you are only looking for short term growth then funds are not for you. As implied above, the price of funds and other investments will go up and down and so you might get back less than you originally put in. Time gives you longer for any downside to improve.
So, how do funds work? Basically, they pool together money from loads of different investors and they use that to buy whatever assets the fund manager is interested in. This could be stocks and shares, bonds, commodities, property, etc. Obviously, the aim of the fund is to make money for those people who have invested in it. It will try and do this either by capital growth or getting regular income via dividends and interest bearing payments.
There are different kinds of investing, when you go directly into stock and shares then you are only investing in one company or, at most, a group of companies. A fund is different. It will be managed by a manger who, hopefully, will know what he is doing. He will also have analysts and researchers looking for the best options to invest in.
Depending on the fund objective, the idea generally would be to invest in a wide spectrum of investments. Invariably, this would be more than most individuals could afford to invest in. As well as this, if someone living in Asia wanted to invest in Africa then it could be difficult for them to do the necessary research into a particular sector. By investing in a fund you circumnavigate this problem. As stated before though, some people may prefer only investing for the short term and so stocks and shares may well be the best form of investment for those particular individuals. However, funds may suit others. In an ideal world people should have both as well as other investments such as physical property and cash itself.
There are various kinds of funds to consider. There are Unit Trusts, Investment Trusts, Exchange Traded Funds (ETFs), Open Ended Investment Companies (OEICs), and Structured Products to name but a few. The most common offshore funds are unit trusts which are very similar to OEICs (the main differences are in the way they are structured legally) but the latter offers shares whereas the former issues units. In both cases, your money goes straight for the manager to invest as he sees fit. When you want to get out of whatever you are in then you just advise the fund that this is the case and the manager buys the units back from you at whatever the going rate is - there can be complications to this as some funds have exit charges or time penalties which may be prohibitive. You need to make sure you know what you are signing up for before giving the fund any money.
For most cases, there is not a limit to the amount of people who can invest in a fund unless it has reached a certain critical mass which may prevent certain strategies or hinders the fund’s actual objectives. If a fund gets to this stage then it will not accept any more money but will continue to manage what is already in the fund. If there are redemptions (people taking money out of the fund) then the manager may allow new investments but only to cover what has been taken out.
The amount of units available increases or decreases according to the how many people want to invest in the fund. The price of the units is based on the Net Asset Value (NAV) which is a valuation of all the assets in the fund minus any liabilities.
Your fund(s) will usually charge an entry fee which will be a one off cost and can be up to five percent of the investment.
Safeguards are also important. Unit trusts have trustees in place to make sure that no improprieties occur. Also, if you invest via a life company in an offshore jurisdiction then there are even more safety nets put in place for you.
To be continued…
A recent report by consultants Rothstein Kass suggests that over the last five years, up to 31st December of last year, hedge and alternative funds run by female managers outperformed those run by men. In 2012 alone, women achieved returns almost 6% higher than men, with a return of just under 9%. Yet, the report states there are only around 100 female hedge or alternative fund managers globally. Also, women tend to run smaller mandates than men and are given less opportunity to take on more senior roles.
The problem with saying things is that you can’t “un-say” them afterwards. Words can hurt and saying sorry doesn’t make the pain go away as though it had never happened. Or as Warren Buffett put it (typically much better than I have) “It takes 20 years to build a reputation and 5 minutes to ruin it.”
One of the factors that has eased the pain of sending money back to Australia lately has been the strength of the Thai Baht. Thai residents earning in local currency have suffered nowhere nearly as badly as those paid in US Dollars (USD) or (God forbid) in Sterling. However, the sustained rebound in the Australian Dollar (AUD), which started in 2008, may well be coming to an end and that could bring with it a whole raft of both risks and opportunities.