Desperately seeking alpha
We have written previously that it has become more difficult for professional money managers to produce the same levels of outperformance (alpha) as in the past. Our research suggests that the performance differential between top quartile equity funds and their peer group average has reduced significantly over the past 10 years, and we believe this trend is likely to continue. For example, over the past 10 years, the performance differential between top quartile global equity funds and the peer group average has narrowed from 1.7% pa to 1.2% pa, a 30% reduction in alpha.
There are a number of possible reasons for this. The rise of indexation, particularly in developed markets, results in a greater proportion of funds with ‘middling’ results. This combined with the tendency of already massive global managers (who are currently taking the lion’s share of industry inflows) to ‘hug the benchmark’ could have the effect of compressing the gap between good and average funds. It may also be a function of the market cycle. We are currently well into an extended bull market. During such times there tends to be less divergence amongst the performance of the individual stocks that make up the market. In periods of market turmoil, this divergence increases, and often sets the scene for greater alpha dispersion going forward.
We believe that the most material impact stems from the fact that the asset management industry has professionalised. A greater proportion of money is now managed by institutions as opposed to individuals. In the US, for example, estimates suggest that the level of direct equity ownership has slipped from over 90% in 1950 to the current level of around 35%. Institutions have clearly been very successful at attracting assets and because of the superior resources at their disposal, have increased the average absolute skill level of participants in the market.
The absolute skill level of market participants has therefore increased prodigiously. This should be reassuring for investors, as far more diligence is being applied to investment decisions. How is it then possible that lower alpha is being produced by top quartile funds? The explanation lies in the fact that alpha is a zero-sum game (all participants combined must earn the market return less costs). To create it, one participant must impart their relative gains as relative losses on other participants. Therefore it is only the difference in relative skill levels that matter, not the absolute level of skill. We believe (and this has certainly been our ‘on-the-ground’ experience over the past 15 years) that the professionalisation of the money management industry has led to convergence and we see more managers adopting similar approaches. But because ‘everyone is doing it’, the differences in relative skill levels have actually decreased, and the gap between top quartile and average funds has reduced.
Where does this leave investors and managers who are in search of alpha? There are three potential routes to relative outperformance:
1. Reduce fees
All things being equal, lower relative fees will enhance relative performance.
2. Play an easier game
There are more alpha opportunities where there is less efficient price discovery. Small caps, for example, are less covered by sell-side analysts, and large managers are often precluded from investing in them due to their size. That is a potentially rewarding combination. Or allowing your manager to invest across asset classes and the capital structure – this allows for a greater amount of alpha opportunities for the skilled investor. The use of derivatives or short selling can also add another dimension to the opportunity set. Alternative asset classes and illiquid instruments can present attractive risk premia if they are not widely followed.
Of course, managers need to be careful when harvesting the illiquidity premium, especially if their investors require more liquidity than they can provide during times of market stress. Interestingly, the Hedge Fund industry grew up on the promise of alpha from these non-standard sources (and a healthy dose of leverage too), but the rapacious nature of some fee structures kept too much of the spoils in the pockets of the fund managers, leaving many investors disappointed with their net returns. Practically speaking, for long-only fund investors, allowing your manager as wide a mandate as possible, and backing a manager whose opportunity set is not limited by the size of the assets that they manage, remains a viable strategy.
3. Improve relative skill levels
This is the most difficult of the three options due to the highly competitive nature of the asset management industry. It can be illustrative to think of the stock market as a complex adaptive system. Complex systems evolve and their past influences their present and future behaviour. In a sense, the collective actions of market participants shape the future of the market; said differently - markets learn. Investors often try and do what has worked in the past. But it may have worked in the past precisely because not many people were doing it. If everyone then adopts the strategies that worked historically, that strategy may in fact no longer work. For example, if everyone believes that purchasing stocks on low-price earnings multiples is a winning strategy (because that has been the case historically), it may become a losing strategy, because the risk premium earned for holding ‘cheap’ stocks will be arbitraged away. The stocks that are cheap will be priced cheaply because they deserve to be, not because the market is overreacting to bad news.
All of this implies that the alpha producers of the future need to be a step or two ahead of the rest. They need to adapt their strategies to be ahead of the consensus on ‘what works’. If we look at where we are as an industry at the moment, the current consensus on ‘what works’ could be described as follows: ‘Valuation-based investing, with a three to five year time horizon, looking for companies with a margin of safety and predictable cashflows’. This all makes perfect sense and has led to reasonable results historically. But almost everyone we meet is now following this approach.
Perhaps, the outperformers of the future will have differentiated approaches. We have met managers who extend their horizon beyond the standard five years. Or those that focus more on long-term compounding potential as opposed to current ‘cheapness’. We know managers that focus the majority of their time on understanding a company’s competitive advantage and the sustainability thereof. Or those focused on companies whose quality will improve over time. A few managers we know look to identify owner operators that are great capital allocators. Spin-offs can be fertile ground too: sometimes disposed of with little regard to price. What’s common among all of these approaches is that they are more qualitative than quantitative; more art than science. They aren’t approaches at are easily modelled on a spreadsheet; they require differentiated thinking. And the sell-side doesn’t readily offer up opinions on these types of situations. It requires a wider, deeper skill-set to operate in this space, and to our mind requires greater skill. Some of these managers may well be a step ahead of the rest over the next 10 years.