The investment world can be split into many camps, but, in discussions of risk, owners and custodians of capital, their agents, academics, analysts and journeymen pitch their tents firmly in one of two camps. In one field we have those for whom risk means the probability of a permanent loss of capital which would cancel all hope of achieving an investment objective. This group will oft reference the Sage of Omaha, Warren Buffet, who has been robust in his observation that risk is not synonymous with the preferred definition of the other camp – volatility.
In business school classrooms, university lecture halls and many of the world’s largest asset managers it has been standard practice to use volatility, or the “spikiness” of a price chart, as a proxy for the risk of a tradeable asset, sector or asset class. The use of volatility stems from the study of the role markets play in setting the price of individual assets in the short term. It is the role of markets to rapidly assimilate information and establish a price. The mechanism by which this is achieved is the assessment of future returns by a myriad of market participants, each of whom will establish a fair value and then trade the asset using deviations from fair value to determine the buy or sell decision. For assets with a clearly defined profile of cash flows, such as a bond, or the equity of a utility company, the assessment will not differ greatly from one participant to the next over short periods of time, and thus, volatility will be low. On the other hand, where there is significant divergence of opinion on the likely outcome for a company, volatility will be higher. Volatility is therefore a measure of the difficulty short term price setters have in understanding likely outcomes for long duration assets.
Friends of Warren would chuckle at the preceding paragraph. The reason for this is that the speculator’s measure of risk is the long-term investor’s friend. Volatility provides long-term investor with the opportunity to reinvest cash flow into an asset at times when the market’s short term view of the asset is unfavourable. The result is that the long-term investor can enhance returns by taking advantage of the market’s near-sightedness.
The use of volatility to assess risk of individual assets is extended to analysis of portfolios and plays a central role in the optimistically named “Modern Portfolio Theory” written by Harry Markowitz in 1952. Sorry Harry, no longer modern but sadly still a theory. We find that the volatility camp will measure the up and down movements of a portfolio and use this as a measure of the risk being taken by the portfolio manager. We now find ourselves in a rather mixed up world with a short-term measure of risk being applied to an activity which is (hopefully) undertaken with a long-term perspective.
Some long-term investors doggedly shun any use of volatility as a measure of risk. We take a more nuanced view. As a measure of investment risk, volatility falls short and simply minimising volatility is not a sure way of avoiding permanent capital loss. This can only be achieved by in depth analysis of prospective investments and selection of only those that meet a sensible set of investment criteria. However, for as long as capital is owned or placed in the trust of humans who bristle with the emotions of fear and greed, volatility will represent a degree of behavioural risk, which, for want of a better expression we might describe as the danger of doing something stupid: a highly volatile portfolio will present, with some regularity, an individual or committee with the opportunity of turning a short term disappointing performance into a long-lasting destruction of capital. The sage advice at these times is: “Don’t just do something, sit there”.
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The growth of passive investment strategies has been supported by a narrative that active management should be shunned in favour of the passive approaches which have disrupted the investment management landscape. We at Cerno remain ardent supporters of well-considered, properly implemented active approaches to investment. Our position is based on our own experience of investing and of our time spent observing active investment managers and the development of passive, or rules based approaches.
The potential rewards to a successfully implemented active investment strategy are significant and are perhaps best exhibited through the example of a savings plan for a new born child. Assuming the parent of a child born in 2016 is willing to make the requisite JISA and ISA contributions and that child is subsequently able to continue with contributions to the age of 65, the uplift from an active approach results in a potential doubling of income in retirement. Chart 1 demonstrates this clearly by assuming a 4% nominal annualised return from a passive approach and a 6% nominal annualised return from an actively managed approach. These assumptions compare with the average return assumption of 7.6% taken by US Public Pension Plans.
These assumptions appear reasonable and correspond with our own experiences: the 2% uplift in return assumption from active management corresponds with the aggregate (net of fees) excess return generated by the Cerno Capital list of approved third party managers while the 6% assumption closely mirrors the return since inception of our core multi-asset strategy.
Chart 1: The Power of Active – JISA to ISA
Alliance Bernstein has recently observed that the introduction of cheap factor driven strategies, typically called Smart Beta, has destroyed any clear differentiation between active and passive. While this stance has some attractions, we believe that we can be clear in defining active and passive approaches as follows:
An active investor will use skill, analysis and judgement to build a portfolio of investments which are expected to deliver an attractive rate of return. The active investor will also avoid investments which are believed to offer unattractive returns or where the potential return is not understood.
Meanwhile, the passive investor defines the asset classes and sectors to invest in (the universe) and then allocates client capital to all investments in that universe. This is typically achieved by investing according to weights set in publically available indices. The passive investor makes no considered assessment of the underlying fundamentals of any individual equity or bond that is bought other than to check that it is included in the relevant index. The passive investor therefore does not care whether his client’s capital is placed in a “good” or “bad” investments in terms of expected return.
The challenge for someone wishing to invest passively is how to deal with the many investment decisions that need to be made in a diversified portfolio. For example;
Chart 2 highlights a typical challenge for the passive investor. The blue line is the FTSE 100 that might be used to track UK equities. But this index is globally facing and concentrated in Energy, Banks, Telecoms and Pharmaceuticals. What about all those great industrial businesses in the UK? Perhaps a more representative index would be the FTSE 250 which has compounded at 8.4% per annum versus 4% per annum for the FTSE 100. This is a huge differential when compounded over a long period. Thus we find two UK equity indices providing two very different investment outcomes.
Chart 2: Which Index?
The passive investor faces similar choices in Fixed Income. The challenges of being passive within one asset class are very evident, but perhaps not insurmountable providing the investor is willing to compromise on potential return. The next challenge is to define a passive approach to allocating between asset classes. Our observation is that the typical approach is to set an allocation based on observation of historical returns and volatilities. Such a backward-looking approach seems at odds with the standard disclaimer “Past performance is not a guide to future returns”.
Our conclusion is that it is impossible to be a truly passive investor or lender as all portfolios need some human judgement. What is clear is that it is possible to be passive in individual asset classes and the exchange traded funds and passive unit trusts offered by passive fund providers form a useful part of the active investor’s toolkit, for example when a short term market opportunity is presented and a simple allocation to the broad market will capture the opportunity effectively.
Passive has gained most traction in the management of equity portfolios. This is to be expected as the earliest index tracking fund was developed to track the Dow Jones Industrials 30 Index. This was followed in 1975 by John Bogle’s Vanguard 500 Index Fund which tracks the S&P500. By 1999, this vehicle managed $100bn. It is within the field of equity portfolio management that there has been most analysis of the ability of investment managers to deliver net of fees performance in excess of a relevant benchmark.
The argument for passive goes along the lines that the majority of equity funds under perform their benchmark index. The small number that do deliver outperformance fail to do so consistently, year in year out. Therefore there is no point in trying to find the ones that do.
The academic backing for this stance is strong. Countless studies show that in most peer groups of equity funds, the average manager underperforms the index.
We would not disagree with this conclusion – if we are scientific and include all relevant data, it is a racing certainty that the average manager will underperform after costs. However, is it not odd to be interested in the average manager? Surely we should be interested in excellent investors? When was the last time an average tennis player won Wimbledon? The more important question is first; are there any managers who deliver net of fees returns in excess of an appropriate index, and second; can we observe commonly recurring characteristics that would allow is to identify them on an ex ante basis?
We can certainly identify the managers with a high probability of producing an average or market like return by looking at their portfolios and working out how much overlap there is with the index. A high level of overlap means the portfolio is unlikely to perform very differently to the index and is therefore not interesting. The name of this measure is active share and a score above 70% is indicative of a highly active portfolio, although allowances must be made for highly concentrated markets such as the UK and Australia where values will be lower. The average score for the equity managers on the Cerno approved list is 90%.
It must be acknowledged that to perform differently to an index, a portfolio needs to be invested differently to that index. The use of active share allows us to make a naive assessment of an investors approach to portfolio construction and to observe whether it is constructed to allow it to perform. We must remember that high active share will not of itself lead to positive returns.
So, if we strip away the closet trackers, what are we left with?
A simple screen of the Morningstar database shows that of the US Equity Funds with a 20 year track record to the end of March 2016, twenty percent have delivered a compound annual return in excess of the S&P500 over the full twenty years. This figure will overstate the true number of funds that outperform given survivorship bias. This analyst’s rule of thumb for the likely opportunity set of skilled investment managers in a given peer group has always been ten percent.
While manager returns can be observed on an ex poste basis, the more important question is whether managers with a high probability of success can be observed on an ex ante basis. Our response is that they can. There are key characteristics that we see repeatedly across excellent investors. The first characteristic is one that surprises many casual observers of the investment problem. When investing in companies or buildings or lending money “active” should not imply activity. The ability to trade successfully and the ability to invest rarely reside in the same person or team. Excellent investors are patient, methodical people who think about the development of a business in terms of years rather than the development of a share price over minutes. Contrast this with the quick minded trader, taking advantage of market psychology on the demand and supply of paper assets. While the popular image of an investment floor involves Bloomberg terminals, flashing lights, phones tucked into bent necks and much shouting, the truth is that excellent investors typically operate in an environment not dissimilar to a library. A number of the great investment teams we follow boast of the absence of Bloomberg terminals on their investment floors.
The result of in depth, patient, fundamental analysis is that excellent investors tend to own companies for many years and often decades. Portfolios can be easily examined to confirm this.
There is academic evidence to support the idea that the pool of patient investors who build idiosyncratic portfolios is an attractive pool for the manager researcher to fish. In their December 2015 paper; Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently, Cremers and Pareek show that a group of US equity managers selected purely on the basis of long duration of holdings and high active share outperformed the S&P by a little over two percent per annum over the twenty year measurement period.
Turnover can be used as a proxy for the patience of an investor although it is not the same thing as duration of holdings and the Cremers and Pareek study does not support its use in place of holding period. High turnover is not necessarily a bad thing, but we tend to be suspicious when we see it.
While portfolio construction (active share) and duration of holdings are quantitative metrics that help define a universe of managers with performance potential, a qualitative approach which focuses on understanding an investment approach and determining soft factors will improve the chances of selecting an investment manager with a high probability of delivering strong performance.
We have observed that investors who can articulate their investment approach clearly and succinctly have typically invested considerable effort into formulating their approach and are therefore well placed to remain committed to the approach during periods of cyclical underperformance. Of course, the manager researcher must have a reasonable understanding of the asset class to be able to determine whether or not the chosen approach is appropriate for the asset class. Moving away from investment strategy, we have observed that the operating environment in which an investor or team sits is a key determinant of success. Investment teams that own the business within which they operate are typically more aligned with clients than hired guns. These investors are also in a position to control the quantum of assets they manage to ensure weight of assets does not erode performance potential as it tends to do when a business is driven by the sales team.
The obvious route here is to direct interest toward boutique investment firms which typically focus on one core strategy in which the founders are long-in-the-tooth specialists. However, the boutique founders of tomorrow may be operating in large organisations today; hence it is important to maintain some coverage of the larger firms to be in a position to move early into boutiques. In addition, there are skilled investors who have found they operate more effectively with the infrastructure of a large organisation and have built a franchise that gives them protected status. As we assess a fund management organisation, the corporate structure adopted is relevant. For example it is easy to contrast the time horizons of the partnership with a listed business and one can observe a very different targets and incentives given to investment professionals.
Finally, we must return to the observation that active investors that do generate outperformance do not do so consistently, year after year. Once again, we must shout “of course they don’t!”
We have established that excellent investors have a clearly articulated investment approach to which they are committed. If these active managers are disciplined and stick to their approach they should deliver attractive returns in excess of any appropriate index over a reasonable time-frame. However, over short periods, stylistic factors come into play. In other words, the approach is either in vogue or not and when it is not, short term performance will likely lag the index. The key takeaway is that relative performance is cyclical. This cyclicality is caused by the preferences of the investment manager which can manifest themselves in sector biases, for example some managers prefer consumer facing businesses over industrials while others are drawn to asset light services businesses and ignore asset rich utilities. Cyclicality is often caused by style with periodic dispersion between value and growth being the most well observed. Chart 3 highlights the prolonged underperformance of value versus growth that began in 2007. Anyone looking at a manager with a deep value bias today should expect to find underperformance and should be wary of managers describing a deep value philosophy while presenting exceptional recent performance.
Chart 3: Style Drives Relative Return CyclicalitySource: Bank Credit Analyst
A failure to appreciate the cyclicality of performance will result in the most common mistake made by fund allocators – buying after strong relative performance and selling after poor relative performance. The buy high, sell low phenomenon is the trap that awaits anyone using performance screens to choose managers. Never ignore the disclaimer: “Past performance is not a guide to future returns”. Historic returns data has only one use – to test the allocator’s knowledge of the investment strategy. If the track record is not understandable given knowledge of the approach, get rid of the manager regardless of whether the track record shows good or bad performance.
Chart 4 demonstrates the patience required of the clients of successful active managers. The chart plots the rolling three year annualised excess return of the IVI European Equity Fund. Over the period, the fund has delivered an attractive average three year annualised excess return of 2.4% per annum. However, to achieve this return, the client has enjoyed a period of great joy and then was perhaps tested in 2014 when the three year number declined to -3% per annum, since when the relative numbers have returned to an upward trend. The message is clear, once a good manager is identified; it pays to stick with them.
Chart 4: Relative Return Cyclicality
The debate between supporters of active and passive investment management will undoubtedly rumble on. Meanwhile, a select group of active managers will continue to deliver benchmark crushing returns for their clients and asset allocators with adhering to the principals outlined here will continue to benefit from the investment skill of this group. To recap, by constraining the search to truly active managers with a long term perspective; who are committed to their discipline and by understanding the manager’s operating environment, the asset allocator stands a better than average chance of selecting funds which can be held for prolonged periods of time and thereby compound returns to create real wealth for clients. By way of a proof statement, the results of Cerno Capital’s approved list managers are shown below. The excess return generated by our list correlated with the 2% outperformance assumed in Chart 1.
Chart 5: Cerno Capital Approved List Performance
Source: Cerno Capital
 Alliance Bernstein, “In Defence of Active Management”, May 2016
 Cremers & Pareek, “Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently”, December 2015
The hunt for income continued in 2015. Equity income investors who were drawn to the energy and materials sectors faced the headwind of commodity price declines. Recent dividend cuts from companies such as Anglo American highlight the risk of a singular focus on yield. The Cerno UK Equity Income Strategy had no direct exposure to these sectors during 2015 having sold a position in Royal Dutch Shell at the end of 2014. The proceeds of this sale were invested in Vodafone. Other than this purchase, portfolio activity for the year was restricted to rebalancing.
Our strategy identifies London Stock Exchange listed businesses which demonstrate a history of dividend progression along with growth, profitability and balance sheet characteristics which suggest the progression of dividends can be maintained. The strategy is concentrated in a small number of positions which are equally weighted and rebalanced routinely.
The performance of the strategy is captioned below:-
Since Inception ^
|Cerno UK Equity Income Strategy||
|FTSE 350 Index||
|FTSE 100 Index||
|FTSE 250 Index||
^ Inception date was 12th April 2013
Note; performance represents the UK Equity Income Strategy which is run as part of a Cerno Capital client portfolio.
Index Data Source; Bloomberg
The largest contributors to performance for 2015 were Greggs and RPC Group. Both companies have been held since inception. Greggs is a UK baker with a strong position in the food-on-the-go market. When the shares were purchased, the market was concerned by the strategy for growth given a large number of retail units in existence. This was not helped by the company exploring ideas which moved away from its core competency of selling competitively priced, freshly made sausage rolls, sandwiches and apple turnovers. The company has subsequently refocused on core values and been proactive in moving retail units closer to customers, which means an increase in transport hub locations relative to high street locations. Capex was also routed to revamping outlets which had become somewhat dated. The board of Greggs has delivered a solid history of dividend growth stretching back to 1991. A period of maintenance rather than growth of dividend while the corporate strategy was reworked provided the opportunity to make our initial purchases on a yield in excess of 4%. The subsequent performance from the company has enabled the board return to growth in the dividend and this was supplemented with a special dividend of 20p per share midway through 2015 – for comparison, interim and final dividend payments for 2015 totalled 22p.
RPC Group is a manufacturer of rigid plastic packaging. The company sells various plastic packaging products to consumer goods manufacturers worldwide. The company is emerging as a consolidator in this sector and has made a number of acquisitions, the most recent of which is the purchase of Global Closure Systems (GCS). The board has delivered a growing dividend stream with average dividend growth of 7% over the last five years.
These two holdings contributed 14% to the strategy return for the year.
The strategy’s holdings in mid cap companies represent 40% of the portfolio and therefore the outperformance of the FTSE 250 versus the FTSE 100 can be viewed as a tailwind over the whole period since inception.
The strategy contains four companies which are more typically considered as income stalwarts of the large cap universe such as British American Tobacco and Vodafone. In aggregate, these have contributed 3% to the 2015 performance.
The large detractor for the year was Pearson which delivered a negative contribution of -3.8%. The company has a long history of dividend progression and this has continued. Pearson is undergoing significant corporate change as it exits from print media businesses and focuses on delivering education to children and adults via digital delivery. The challenges of monetising Pearson’s intellectual capital are increasingly evident and this resulted in significant weakness in the shares.
The portfolio received ordinary dividend receipts in 2015 that were 5.5% higher than 2014. This excludes special dividends.
The yield on the portfolio of 3.4% is currently lower than that offered by the FTSE 350 Index which is 4.1%. This lower yield is a result of the portfolio holding no exposure to the materials and energy sector where optical yields are high; however the risk of dividend cuts is also high.
Share buybacks, or the repurchase of shares by listed companies is a popular use of listed companies’ cash. Repurchased shares are initially held in treasury which means they do not qualify for dividends or voting rights. If treasury shares are subsequently retired, this provides a stronger signal on the intentions of management. From the long term shareholder’s perspective, a buyback is viewed positively because the reduced share count increases all other shareholders’ percentage ownership of the company. Of course, the value of the company has declined by the amount of cash used to repurchase the shares.
A buyback impacts per share data. Therefore, an immediate benefit to shareholders of a buyback is the reduction in share-count which increases dividend per share assuming there is no reduction in the total amount of cash set aside for dividend distribution. The corresponding benefit to management is an increase in earnings per share; many incentives are based on earnings per share growth data, rather than aggregate earnings growth or return on invested capital metrics.
It is therefore understandable in a world of income starved investors and incentivised corporate managers that buybacks are generally welcomed. Indeed, some commentators have been tempted to add the dividend yield to the percentage of shares bought-back to come up with a dividend plus buyback yield. While this might be appropriate at the individual company level, the extension of this type of analysis to the aggregate market level should be treated with caution. A recent paper by Chris Brightman of Research Affiliates provides a more thorough analysis of the activities of companies buying back their shares in the US.
Are Buybacks an Oasis or a Mirage?
In particular, he highlights the appearance of some of the largest repurchasers of stock on the list of largest issuers. Why would a company buy back shares only to reissue? Typically, to fulfil stock compensation plans. In other words, companies may be repurchasing shares in order to give them to management – hence the need to see companies retiring equity rather than holding in treasury for use as compensation plans vest. Brightman correctly observes that it is wrong to only look at the equity component of the balance sheet; an assessment of debt issuance is also important. He notes that total debt issuance by US corporates in 2014 was US$1.2 trillion. How much of this was used to repurchase stock as opposed to funding growth in operations? Brightman points to a study by his colleague Rob Arnott that observes average dilution through aggregate net issuance of equity on the US Equity Market of 1.7% per annum since 1935. This would go a long way to wiping out the yield impact of buybacks.
This analysis backs up the view we, at Cerno Capital, hold on buybacks – they are a tool of the financial engineers at work within companies (and their advisors) and should be analysed on a case by case basis within the context of the whole capital structure of a business. Most crucially, share buybacks cannot directly alter the operating performance of a company; however, financial engineers can use them to alter the distribution of profits from operations and it is the job of the equity analyst to identify whether or not shareholders are being treated appropriately.
For a full analysis of the value created by share buybacks, we recommend the following article from the consultants at McKinsey;
The value of share buybacks
“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” – John D. Rockefeller
A discussion of dividends or income can lead to glazed eyes of some equity market participants. Hot-handed momentum traders care only for the greater fool who will pay a higher price for their slice of equity. Long-term growth investors may well be invested in companies at the pre-profitability stage and hence dividends are not on the agenda. Alternatively, some investors believe in the capital allocation credentials of their management teams to the extent they entrust management to reallocate all profits on their behalf.
Meanwhile, the income investor knows exactly when his or her companies go ex-dividend, and feels Rockefeller’s embrace when the pay date comes and the dividend shows up on the daily cash sheet.
In truth, an interest in dividends is a hall mark of the equity investor. Equity is nothing more than the sliver of hope that separates assets from liabilities. The owner of common equity is entitled to nothing other than any dividend that might be declared by the board of directors.
Of course, the knowledge that dividends are important is no guarantee of success. The greatest risk is being blinded by the light emanating from a company with an exceptionally high current yield (most recent 12 month dividend divided by current price). This light should be treated as emanating from a light-house. Purchasing these equities can be a perilous exercise akin to an attempt to shortcut a headland by sailing over skerry infested waters. Dividend cuts can sink a portfolio.
It is not the yield at time of purchase that dictates the success of an equity investment, rather, the growth of that dividend over the holding period. To demonstrate this, the chart below shows the development of portfolio valuation from four different dividend growth scenarios:
Source: Cerno Capital
In each case, the starting yield on the portfolio is 3%. We have assumed dividends are reinvested and taken the analysis out for twenty years. We have also assumed no valuation change in the pricing of the investments. The message is very clear: if an investor has a long time horizon, for example, someone in their forties looking to make investments that will provide income beyond retirement, the rate of dividend growth is the key determinant of investment success. The growth in dividends (the G in D from our title) will substantially account for the price appreciation of the asset.
To emphasise this point, an investor in a no dividend growth portfolio might receive £5.41 in year twenty. Meanwhile, an investor in a 10% dividend growth portfolio will receive a dividend cheque of £103 in year twenty.
If we give the zero dividend growth portfolio a head start of an initial yield of 5% and assume the dividend survives, the 10% dividend growth portfolio has overtaken the no dividend growth portfolio by year ten and by year twenty is producing seven times the dividends of the former.
At this juncture, it is tempting to suggest a strategy which looks for those companies that have high historic dividend growth rates. Such a strategy has some merit. However, it would be backward looking and would completely miss the point that high dividend growth is the product of a successful business that is run by management which acknowledges the interests of shareholders. Growing dividends can only be produced by companies which generate cash rather than paper profits and which have a dominant industry position that allows them to maintain their profit margins over a prolonged period of time.
These are the types of companies targeted by the Cerno Global Leaders Strategy. Our selection criteria are tightly defined and forward looking. The level of dividend or its history is not one of our criteria. However, the companies we own today have an average five year dividend growth rate of 11.3%. Our intention is to hold these companies for a very long time.
We look forward to counting our dividends.
For further information about the Cerno Global Leaders, invested as part of our core investment strategy, please refer to the TM Cerno Select Fund webpage.
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Within global equity markets, April saw value style indices outperform growth style indices. The relative return of one style versus the other would not typically be a significant event and the relative outperformance was just 1% according to the Russell Global Style Indices. However, the prolonged period of underperformance of the value style versus growth (a 5% difference over the last year and a 37% difference since 2005) and the associated headwind for equity investors with pronounced value style bias means that observers are in a mood to call for a change in trend.
Can we observe a similar pattern in active manager universe data? For reliable style universe data we look to the Morningstar US large cap value and growth peer groups. The median value manager has underperformed the value and broad market indices over the last five years while outperforming over one and three months. Meanwhile the median growth manager has lagged the growth and broad market indices over the last month after a prolonged period of outperformance over the broad index (the median growth manager rarely outpaces the growth index).
So perhaps we are onto something? It is important to remember that a value style index is a naively implemented strategy which will typically have high allocations to companies which are optically cheap on asset and earnings multiples. There is also a tendency for value style indices to hold high weights in cyclical industries when trailing multiples suggest value, because the equity market discounts a cyclical decline in earnings. We must therefore look to the underlying composition of the style indices.
When we do this, the picture becomes clearer. The largest sectors in the Russell Global Value Index are Financial Services and Energy – two beleaguered sectors which performed strongly in April.
So it appears that we are really looking at a sector effect. Peering further into the data can provide some support for this stance. The outperformance of value over growth in Latin America, again according to the Russell Indices was 9%, a much greater differential driven by the significant weighting in extractive industries within the Latam area. The picture is murkier in Asia ex Japan, a region with a much lower weight to Energy, but a high weight in Financials, particularly in China which rallied hard in April. The headline style indices suggest value also outperformed in April. However, the style team at UBS performs a much more granular assessment of style returns than the major index providers and they found that value styles continued to fare poorly across Asia.
Does any of this help us in managing our equity allocation? Emphasising value over growth is very different to implementing a valuation discipline – we would always argue in favour of the latter. Given the driver of style returns appears to continue to be sector, it makes more sense to spend time making sure stock and sector exposures are supported by a sound investment thesis. cheap hotels . With regards to manager selection, deep value managers with an unconstrained approach to sectors are the group with the most to gain from sector reversals – just be certain they are not holding value-traps enjoying a dead cat bounce.
This article first appeared in Wealth Manager magazine.
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In short, not much. Like any attempt to reduce a complex process to a digit, it fails as an investment assessment tool.
“Active Share” is the number you get when you sum the difference between the weight of a stock in a portfolio and the weight of that stock in an appropriate benchmark for all stocks in the benchmark. The maximum score on this basis is 200%. We can simply divide by two or agree to only sum the overweight positions to arrive at a figure where the maximum score is 100%.
The score is an attempt to measure the risk that fund is taking – but note that we are talking about relative risk versus an index rather than absolute risk (the probability of a permanent loss of capital). By using current holdings, the score is not a rear view mirror measure of relative risk in the way that tracking error (the standard deviation of relative returns) is.
It is not a new concept. This analyst well remembers being admonished by his CIO for calculating such a “one dimensional and potentially misleading metric” in 2003. The measure was given academic credentials in 2006 by Martijn Cremers and Antti Petajisto of the Yale School of Management.
Active share or “active money” has received much press of late – a google search gives us 288 million hits. Some in the manager research community have proposed investors should only look at actively managed funds with a high active share score. The assertion is that funds with a low score are effectively index trackers charging active management fees. They cling to the observation that the average excess return from high active share managers is positive and significant while the average for lower active score managers is close to benchmark.
The problem with this analysis is that it takes no account of manager skill. A high active share score means that there is potential for the portfolio to deviate significantly from the path of the benchmark over a short period of time – nothing more. Who would you back: Fangio in a Ford or Bob the Builder in a Bugatti? Surely it is right that if unskilled journeymen are to be allowed to manage a portfolio he or she should be constrained to limit the damage? “Skill” was renamed by Messrs Grinold and Kahn as the information coefficient. If a manager has a positive information coefficient, then Active Share score will simply provide guidance on portfolio construction. The Active Share score cannot tell us whether or not skill exists – this can only be achieved through rigorous, detailed and consistently applied manager research of the qualitative variety.
A succinct and well observed assessment of Active Share has been penned by Rob Harris, CEO of Majedie Asset Management. He reminds us that Active Share is determined by the nature of the benchmark selected – is it concentrated in a small number of large companies for example? If the answer is yes and those companies are fundamentally attractive, would you want your manager to avoid them simply to increase their Active Share score? He draws on his experience as part of a team which has delivered an annualised excess return of 4.2% against the FTSE All-Share Index since July 2003 with an Active Share that has varied between 50%-60%. This level of active money would see a fund placed in the “index huggers to avoid” bucket by myopic manager researchers. This analyst can confirm that Majedie have been consistent as their UK strategy was part of the calculation described as “one dimensional and myopic” in 2003.
The investment group at Cerno Capital is principally concerned with assessing the return potential of investments. When we do select an active manager, our qualitative analysis has determined that they are truly active, regardless of any Active Share score.
I recently met Colin. He has the longest unbroken track record in the UK Equity Income sector.
We did not talk about his Income fund; instead, we talked about his Blue Chip Equity Fund, which, notwithstanding a long track record has seen assets dwindle as investors joined the passive bandwagon – predominantly through Exchange Traded Funds (ETFs). Colin’s fund will be converted into a UK Rising Dividends Fund. The strategy makes a great deal of sense – focus on businesses with a track record of dividend growth and with the potential to maintain that growth. A set of rules whittle his universe down to a manageable list, then his experience and brain take over.
The challenge for Colin is that the passive ferry may have already picked up his potential passengers. The growth in ETF-land is now focused on “Smart Beta”, “Factors” or “Advanced Beta”. The terminology proliferates as quickly as the number of ETFs. domain name search Total assets under management (AUM) in these products exceeds half a trillion dollars.
If an active strategy can be defined by a set of rules using publicly available data, an index can be calculated and an ETF can be created to passively track that active strategy. We have recently witnessed a slew of ETFs offering exposure to “Value”, “Momentum”, “Quality”, “Size” and “Minimum Volatility”.
So, the world of passive is increasingly active, aggressively so, but is the man at the tiller awake? We know that the weight of AUM following any given strategy has an impact on potential returns. Even P&O’s finest ships have a finite capacity for passengers, cross that limit and the ferry begins to sink.
And what of Colin? Naïve dividend ETFs have been with us for some time – they were loaded up with high yielders prior to the Financial Crisis and holders quickly experienced the pain of dividend cuts – the pay-out on the iShares UK Dividend ETF is still 29% below the peak in 2008; its current largest holding is a supermarket. Colin understands that investment management is a blend of art and science and is very much alert and in control of his tiller.
Typing “Smart Beta” into Google yields sixty-four million hits. Close to the top of the list is the headline “Smart Beta – The Investing Buzzword that Won’t – and Needn’t – Die”. For every advocate there is a cynic such as GMO’s James Montier who coined the equation “Smart Beta = Dumb Beta + Smart Marketing”. Montier observes that many of these ETFs seek to capture a premium attributed to one of two factors; Value and Size.
So, let’s be clear, most strategies labelled as Smart Beta, are in truth portfolios designed to capture the returns from a particular factor of which Value, Size, Momentum and Quality are the most well-known. Investment strategies targeting one or more of these factors are not new. Wells Fargo’s investment business became a leader in passive equity investment between 1975 and 1990 when it merged with Nikko Investment Advisors and developed factor tilt portfolios that became a staple product of Barclays Global Investors (BGI) which was the business created by the purchase of Wells Fargo Nikko Investment Advisors by Barclays PLC in 1995. BGI spawned iShares and was subsequently subsumed by BlackRock. Meanwhile State Street Global Investors, Goldman Sachs Asset Management and many more specialist asset managers, of which BGI was the leader, met a seemingly insatiable demand for low-tracking error, quantitatively implemented portfolios that delivered, according to back-tests, the holy grail of benchmark plus 2%. Marketing materials talked about high levels of diversification. But were they? Almost without exception these strategies combined value, size, quality and momentum and some added a bit of leverage. The result was inevitable – too much money chasing the same stocks – and what become known as the quant crash of August 2007, triggered by the unwinding of a leveraged multi-factor portfolio.
Smart Beta Exchange Traded Products allow all investors to chase these factors.
Why are factors so attractive? From the investor’s perspective, the act of committing capital requires the assessment of uncertainties and the application of probabilities to make decisions. Uncertainty makes humans uncomfortable. If science or academia can offer us certainty, we believe we will sleep better, convinced we have found a free lunch. From the scientist’s perspective, the equity market provides an almost infinite quantity of his favourite food – data. And if tortured enough, this data will reveal powerful secrets which may well support prior beliefs. Fama and French told us about Size and Value in 1993, at the same time Jagadeesh & Titman showed us the power of momentum and then received support from Hong and Stein in 1999. The work of Piotroski in 2000 found that “quality” is another route to equity investment success. The work of Grinold and Kahn in 1995 (the orchestrators of BGI) demonstrated how this work could be pulled together to deliver investment success. Their book is seminal reading for all quantitatively oriented investors. This work appeared to offer certainty.
This certainty is dangerous. Blindly following a factor based strategy will lead investors into the same companies as others following the same factors – and there will be many as the research papers reside in the public domain as academics must be published to achieve peer review. This was observed in August 2007 when a leveraged factor portfolio, allegedly run by Goldman Sachs, was unwound and triggered a wave of selling across all similar “smart beta” portfolios which unwound years of carefully nurtured “alpha”.
Two days ago, we were sent some marketing documents for an Equity Risk Premia Beta Neutralised Portfolio. It is available in both UCITS compliant OEIC form or as an ETF. All the investor is asked for is their choice of leverage – will sir be taking 3x or 5x today?
Here we go again………
Friday, September 26th 2014 will be etched into the memory of followers of investment management companies and fixed income investors alike. Shortly after lunchtime, when London based manager researchers and consultants were probably settling down to an afternoon of email inbox and desk tidying, Janus Capital announced the recruitment of William “Bill” H Gross. Indeed, many will have missed this given the high likelihood of an email from Janus being ignored or deleted (Janus has struggled to reinvent itself after riding the tech bubble up and down and then becoming embroiled in the 2003 market timing scandal).
Within minutes the newswires were alive with the news that PIMCO – Bill Gross’ home for the last 43 years – eventually confirmed in a statement which confirmed the general observation that relationships within PIMCOs Investment Committee and with the business heads had become increasingly challenging.
This is the “big one” which will have transition managers salivating. Investment manager moves are not uncommon; sometimes they run a few hundred million dollars, maybe a few billion. Occasionally, a manager is responsible for a few tens of billions of dollars. The size of the AUM under a managers’ control will typically determine the workload for the manager research and investment consulting community along with the number of words written by journalists. Bill Gross is best known as the manager of the US$220bn Total Return Bond Fund and was the named portfolio manager on 27 PIMCO Funds and ETFs according to their own press release. It is probable he was named manager on many more segregated accounts run for pension funds and other institutions. As CIO of PIMCO, and given Gross’ temperament, he will have had some level of influence on every one of the US$2 trillion dollars managed by PIMCO.
The very scale of these figures is overwhelming and they are all well reported in the press which means the ‘phone of every manager researcher or investment consultant with exposure to PIMCO will be ringing and the inbox will fill up faster than he or she can press delete. Anyone tasked with coming to a reasoned opinion on the strategies that were run by Bill Gross, other PIMCO strategies and indeed PIMCO as an investment house should turn the newswires off and the Do Not Disturb button on. It behoves these consultants to now think clearly and advise their clients about PIMCO ex Gross.
Bill Gross led the investment team of PIMCO.
There was a clearly articulated investment process built around regular meetings of the upper echelons of the investment team, a team which has been expanded significantly over recent years. Depending on which of the new CIOs you speak to, PIMCO has between 240 and 400 portfolio managers.
In their communications so far, PIMCO have noted that until Friday 26th September, the investment competency operated on a founder-led model.
In plain English, this means that Bill Gross determined investment policy and strategy.
This agrees with our understanding of Bill Gross’ level of influence across the firm, built from conversations with employees past and present. The highly structured investment process allowed the firm to run a huge book of business efficiently (PIMCOs operational protocols are top-notch). Going forward, PIMCO will operate a team based model. To this end, PIMCO now has a Group CIO; Dan Ivascyn and five additional CIOs; Andrew Balls, CIO Global; Mark Kiesel, CIO Global Credit; Virginie Maisonneuve, CIO Equities; Scott Mather, CIO US Core Strategies; and Mihir Worah, CIO Real Return and Asset Allocation.
What is the collective term for a group of Chief Investment Officers? A clutch? A huddle? For evidence of this move to a team approach, we can see that on all the high profile fund strategies, a single named portfolio manager (Gross or Scott Mather) has been replaced with a team of two or three portfolio managers. These managers are going to have to spend time with manager researchers to demonstrate clear lines of accountability within this approach. They must convince investors of their ability to adapt to a new operating model – notwithstanding any protestations that they are just “doing what they have always done”.
We were told on a conference call by PIMCO’s President that Bill Gross’ departure marked the “conclusion of a prolonged period of succession planning”. This indicates that the aforementioned CIOs and others have been positioning themselves over the last year to achieve their own personal ambitions. Hence, the new structure may well be the result of a series of horse trades. There will undoubtedly be disappointments which can lead to resentment, dysfunction and, ultimately, departures. A high level of organisational instability is a clear and present danger. Of course, the fact that Gross has turned his back on the team could unite the wider group in the same way as the presence of a management consultant can act as the focus of hostility in a dysfunctional organisation causing team members to put differences aside and work together towards a shared goal. Only time will tell and for now we have a high level of uncertainty around the organisational environment in which PIMCO’s investment team members operate.
At Cerno Capital, our preference is to be confident that the investment managers we entrust with capital are sitting in a stable environment which allows them to give their full attention to investment issues when they choose to do so.
Clients of PIMCO will look to the underlying exposure of their accounts as part of their analysis of the situation. A portfolio of US Treasuries has a very different complexion in comparison with an unconstrained bond fund or a total return bond fund – the favoured strategies of Bill Gross who has historically made significant use of credit, derivative overlays and securities, a concoction which is plainly not vanilla.
It is reasonable to expect some of the assets previously managed by Bill Gross to follow him to Janus; likewise it is reasonable to expect some clients to look for a manager with less organisational risk.
This inevitably leads to a consideration of liquidity as concern grows over a destabilising event in the markets. PIMCO have so far told us that “the bond market is big”, “people forget how liquid the bond markets are” and “cash and treasury holdings are high as a result of our new neutral hypothesis”.
It is true that bond markets are big; it is also true that PIMCO is big and it is true that size does not in itself infer liquidity. Some people may have forgotten what the over-riding level of liquidity is in bond markets, but most investment managers we talk to remind us regularly that liquidity in credit markets is exceptionally poor given changes in market structure since the financial crisis. Cash and treasury holdings may be high relative to PIMCO’s recent history, but the Total Return Bond Fund exposures to MBS, credit and emerging market debt remain significant at 41 percent of total market value according to PIMCOs last summary. In specie transfers, particularly in PIMCO’s book of segregated accounts would reduce any short term market impact, however, it is reasonable to expect some turnover and leveraged investors are likely to try to get ahead of any PIMCO position unwind.
Some might view it as fitting if events resulting from Bill Gross’ departure mark a significant juncture in the history of fixed income markets.
At the risk of sounding like a broken record, the organisational risk presented by significant outflow surely outweighs any short term market impact for an existing or potential client of Gross’ former shop. PIMCO have told us that they have hired significant numbers of people in recent years. PIMCOs revenues are tied to their asset base. If assets shrink, revenues shrink and the cost base (staff numbers) may have to shrink to retain profitability. A shrinking firm is rarely a happy firm.
Then, there is a potential impact on investment performance if outflows are sizeable and prolonged. Redemptions are funded by cash and payments will therefore lift the percentage of a fund exposed to less liquid assets. If selling pressure is maintained in the less liquid parts of the portfolio, the performance impact is magnified as the portfolio moves further away from the portfolio manager’s targeted allocations. Furthermore, there is the danger of a negative psychological impact from a continual stream of redemptions that can result in portfolio managers simply throwing in the towel – typically at the point of maximum pain.
The allocator or manager researcher tasked with delivering an opinion on a PIMCO strategy or on the firm must assess the above risks and place probabilities on the outcomes. To do so will require an intimate knowledge of the processes in place at PIMCO and of the relevant individuals and their relationships within the broader firm. With a firm the size of PIMCO, this knowledge can only be accumulated over many years of working with PIMCO.
PIMCO’s clearly presented investment approach, its well-resourced investment team and highly efficient operational structure has enabled it to run large blocks of capital in both tightly defined and more unconstrained investment mandates. The efficiencies of scale result in an ability to offer active portfolio management at relatively low cost. This has allowed PIMCO to become the fixed income manager of choice on many consultant buy-lists and gather large numbers of segregated accounts from institutions and addition to institutional subscriptions to its pooled vehicles.
The investment team at Cerno maintains an approved list of manager strategies from which we construct portfolios, a key difference when compared to a consultant buy list is that we do not require multiple options in each asset sub-class, in order to cope with the multi-billion dollar accounts which follow consultant recommendations. This naturally steers us away from asset gatherers and towards firms where investment performance is the number one priority. Furthermore, access to key decision makers is a core tenet of our approach and while this is easily obtainable by look to investment boutiques, we are also able to navigate the corridors of some larger operations where we can locate like-minded investment professionals who can clearly articulate an approach which we believe will make money and crucially, who have a clear thought process around the capacity of their strategy.
Cerno Capital client portfolios have no exposure to any PIMCO funds.
Clifford Asness is the founding principal of AQR Capital Management. AQR is a US based, SEC registered investment advisor with approximately US$98bn under management in asset allocation and stock selection strategies which are mostly quantitatively implemented. Asness is a regular contributor to the Financial Analysts Journal and a deep thinking investor. In the latest copy of the FAJ he has a bit of fun by articulating a list of peeves. The full article is available by clicking here.
He observes a number of statements which are all too familiar and infuriating to hear; Commentators observe “bubbles” far too regularly, we agree, US Treasury Bills offers an exceptionally low return, but a return which can be justified by a reasonable argument nonetheless. Baltimore Technologies, in December 1999 certainly did not. “Arbitrage” is too often used to describe “a trade we like” rather than its true definition; “a riskless profit”. We’ve encountered this all too often in our often search for skilled investment managers. Then there are the market strategists who tell us about “cash on the side-lines”; there are no side-lines!
As a practitioner, Asness embraces technological advance; while some view High-Frequency Trading as a black-box evil, Asness rightly observes that market making on this basis has lowered the taxes that are transaction costs to the benefit of all market participants. He is less welcoming of “smart beta”. First, these products do not track market cap weighted benchmarks and should therefore be viewed as active strategies and not “better ways to gain market exposure”. Second, many implement a value and momentum strategy which are two factors very close to Asness’ heart.
Our view of risk is the chance of a permanent loss of capital. Asness doesn’t disagree but is quick to remind us that only dumb quants would use volatility without a corresponding expected return. I wonder what reaction “minimum variance strategy” elicits?
Emerging equity markets enjoyed a decade of relative outperformance over developed equity markets up to 2010. Since then, emerging equity markets have underperformed.
Headline valuations suggest emerging value in emerging equity markets. However we doubt whether the time is propitious and we remain cautious.
Furthermore, the emerging equity universe should not be treated as a homogenous block. A top-down allocation model driven by country of listing is no longer sufficient given the increasing level of exposure to the emerging markets of developed market listed businesses.
We question the extent to which institutional investors fully understand their emerging market equity exposure.
Turning to the debt of the class, emerging market debt (EM debt) returns can be attributed to a number of factors including credit spread, carry and the risk free rate. We believe that the risk free rate will be subject to upward pressure over the coming quarters and this will present a further headwind for EM debt.
Institutional debt investors are enrolled in a vow of silence as to the liquidity characteristics of their markets. EM debt does not trade on exchanges, as equities do, and investment banks carry low inventories. Easy to buy, hard to sell and therefore dangerous.
The UK government is to sell the 500-year-old Royal Mail. Veteran dealmaker James Leigh-Pemberton is to take on the helm of UK Financial Investments with its holding in Lloyds in his sights.
Will the sale of Royal Mail come with a “Busby” or “Tell Sid” campaign familiar to those who lived through the BT and British Gas privatisations of 1984 and 1986 respectively? Both events took place during a well-entrenched equity bull market.
The Royal Mail sale comes four years into a bull market which began in early 2009 and has made progress ever since, notwithstanding repetitive summer-time blues. The MSCI World Index has delivered a total return of +16% per annum in sterling terms in the period from March 2009 to August 2013.
We have postulated that the stop-start nature of recovery since 2008 has held animal spirits in the corporate world at bay. Certainly, data from Mergermarket shows that while the equity markets have regained their highs, the value of M&A remains depressed in comparison.
This summer has been marked by an absence of crisis news-flow and a continuation of a strong bull-market in equities. We have also witnessed the announcement of the sale of Vodafone’s stake in Verizon Wireless to Verizon Communications for US$130bn. This is a deal that for a long time has been placed in the “too difficult” box. It is also a deal which results in Verizon making a record-setting US$49bn bond issue to fund the purchase. While Vodafone will return cash to shareholders, it also intends to go on an acquisition spree in Europe in addition to the current purchase of Kabel Deutschland.
Closer to home, construction firm Kier Group has bought May Gurney – the guardian of much of our motorway network. Meanwhile a small Midlands industrial property investor with a 23 year record of dividend increases has made a couple of purchases after 4 years of inactivity.
The first signs of mega-deals and anecdotal activity of rising corporate activity suggests that multi-strategy managers should be revising prospects for Event Driven managers.
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