Senate group; Why skill is never enough - November 2013

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Senate group; Why skill is never enough - November 2013

  1. 1. Why Chasing Skill is Never Enough! How to build better investment portfolios without skill Roland Rousseau Quantitative Portfolio Construction Research Roland Rousseau – Portfolio Construction Research – November 2013 1
  2. 2. What do Investors Really, Really Need? Do we need skill-based performance? Investors need a return that covers or exceeds their opportunity cost of not investing They need an excess return (e.g. above inflation, benchmark, liabilities etc) They need a positive return after costs They need a return without excessive ‘risk’ Excess Return Acceptable Costs Value for Money Is skill-based performance Necessary and Sufficient to achieve your investment goals? Tolerable Risk Let’s see… Roland Rousseau – Portfolio Construction Research – November 2013 2 2
  3. 3. What Returns can we expect without skill? Portfolio Weights and Returns (pa) since 1985 ALBI ALSI Cash Offshore Return 60% 20% 10% 10% 15.3% 50% 30% 10% 10% 15.6% 40% 40% 10% 10% 15.9% 30% 50% 10% 10% 16.1% 20% 60% 10% 10% 16.2% 15% 70% 10% 5% 16.6% CPI Inflation (pa) since 1985 8,4% Source: Barclays, ABSA Capital, Inet 16.6% Long-Term Portfolio Returns for different Equity Allocations 15.6% 15.9% 16.1% 16.2% 15.3% 20% 30% 40% 50% 60% 70% Source: Barclays, ABSA Capital, Inet Roland Rousseau – Portfolio Construction Research – November 2013 3
  4. 4. “Mommy, where do Excess Returns come from?” Return = risk free rate + 10% = 2% ± Exposure to Equity factor Exposure to Bond factor Exposure to Currency factor Exposure to commodity factor Exposure to Emerging Market factor Exposure to Value factor 7% + uncorrelated excess skill from fund manager ± 1% Skill is the residual excess-return, after ALL returns from the risks have been accounted for Up to 90% of excess returns come primarily from excess risk, not skill! Risks are out of our control. We should not take blame or credit for them Roland Rousseau – Portfolio Construction Research – November 2013 4
  5. 5. Are we using the right benchmarks? Higher Risk = Higher Return, regardless of skill What are the odds of choosing a portfolio with a return higher than eg. CPI+5%? Same risk Equal weight (ie no skill) Higher Risk = Higher Return without skill! Source: Barclays, ABSA Capital, Inet Roland Rousseau – Portfolio Construction Research – November 2013 5 5
  6. 6. Battle of the Giants: Allan Gray vs. Coronation Compound Performances are very misleading 1200 1000 800 30% Bonds 65% Equity 5% Cash Allan Gray Balanced Fund Coronation Balanced Fund CPI+7% CPI 600 400 200 0 Source: Barclays, ABSA Capital, Inet, Morningstar 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Roland Rousseau – Portfolio Construction Research – November 2013 6
  7. 7. Relative Performances are more informative Relative to arbitrary Balanced Fund: 30% Bonds + 65% Equity + 5% Cash 2.2 2.0 Allan Gray Balanced Fund relative performance Coronation Balanced Fund relative performance 1.8 1.6 1.4 1.2 1.0 0.8 Source: Barclays, ABSA Capital, Inet, Morningstar 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Roland Rousseau – Portfolio Construction Research – November 2013 7
  8. 8. Part II: Building more efficient portfolios
  9. 9. Building more efficient forecasts Memorable Average (invest more efficiently) (invest like everyone else) • Use inconsistent benchmarks • Focus on active – return (alpha) • Chase past performance YOUR INVESTMENT CHOICE • Fair and relevant benchmarks • Focus on active – risk (beta) • Only pay for real skill Roland Rousseau – Portfolio Construction Research – November 2013 9
  10. 10. Getting the Basics Right first … STEP 1: STEP 2: Choose a long-term, strategic, risk-profile for your client (asset allocation) Invest in low-cost core portfolio (i.e. passive) STEP 4: STEP 3: Manage risk actively within core portfolio Choose active funds that deliver true skill (not risk that is disguised as skill) Watch this space! Roland Rousseau – Portfolio Construction Research – November 2013 10
  11. 11. Risks are valuable sources of returns! Risk-Factors Risk-Factor - Interest rates - Currency - Inflation - Volatility Risk-Premia - Equity, Bonds, Credit Risk - Event, Structural Risk - Liquidity Risk - Emerging Markets - Property, Art, Wine, Timber Accounting Risk-Premia - Book-to-Market Ratio - Cash-Flow to Price Behavioural Risk-Premia Return Quality, ability to ’predict/model’ eg currency, interest rates Risk-Premium eg. equity, value, momentum, small caps, emerging mkts Outperformance without active skill!! But Risk-Premia are risky (eg Value)! - Momentum - Price Reversals - Earnings surprises/revisions Roland Rousseau – Portfolio Construction Research – November 2013 11
  12. 12. ‘Value’ Risk Premium using DY 900 21% pa Super Duper Fund X 800 FTSE/JSE Div+ Index (J259T) 30 highest DY stocks FTSE/JSE ALSI (J203T) 700 16% pa 600 500 400 300 200 100 0 2002 2003 2004 2005 2006 2007 2008 2009 Roland Rousseau – Portfolio Construction Research – November 2013 2010 12 2011 2012 2013
  13. 13. SA Benchmarking Issues: Peer Group Surveys Top 20 General Equity Funds (3 years) 1 PSG Equity D 181.33 2 PSG Equity A 177.34 3 Discovery Equity 176.76 4 SIM General Equity B5 176.54 5 PSG Equity B 176.09 6 Foord Equity R 175.92 7 ABSA Select Equity 174.71 8 Marriott Dividend Growth R 174.28 9 SIM General Equity B4 173.69 10 SIM General Equity R 173.32 11 SIM General Equity A 172.21 12 PSG Equity C 172.20 13 Investec Active Quants Z 171.96 14 Old Mutual High Yield Opp A 171.68 15 Coronation Equity R 171.54 16 Aylett Equity A3 171.25 17 Old Mutual RAFI 40 Tracker B1 170.88 18 Metropolitan Multi-Manager Equity 170.40 19 Coronation Equity B2 170.37 20 Kagiso Equity Alpha 170.10 We always chase the Top Managers Source: Morningstar Inconvenient Facts and Truths  167 General Equity Funds over period  FTSE/JSE Top 40 ranked 34/167 (80%)  FTSE/JSE ALSI ranked 30/167 (82%)  FTSE/JSE RAFI ranked 28/167 (83%)  FTSE/JSE SWIX ranked 24/167 (86%)  FTSE/JSE Eq. weighted Top 40 8/167 (95%)  FTSE/JSE Div+ ranked 1/167 (100%) Why are investors not being told about low-cost, high performance, index funds? Roland Rousseau – Portfolio Construction Research – November 2013 13
  14. 14. Indices and CPI are not Benchmarks! Index: collection of stocks that are weighted to capture some market effect Benchmark: yardstick to measure and incentivise a fund manager’s skill against Return Target: a goal or expectation for an average return over time (eg CPI+x%) How can we beat the balanced-fund benchmark without skill: 60% Equity, 30% Bonds, 10% Cash? Overweight Equities – ERP 3-6% pa How can we beat the FTSE100 without skill? Overweight value stocks or small caps – VRP 3-5%pa How can we beat the MSCI World Index without skill? Overweight Emerging Markets – EMRP 2-5% pa Roland Rousseau – Portfolio Construction Research – November 2013 14
  15. 15. Risks are out of our control/influence! Ben 2 tons per hectare Which farmer is better? Roy 4 tons per hectare What if Farmer Roy had double the rainfall? We cannot take credit/blame for the rainfall (ie risks) and therefore they need to be stripped out of our performance! Roland Rousseau – Portfolio Construction Research – November 2013 15
  16. 16. SA Benchmarking Problems: Beware CPI Benchmarks Good Benchmarks need to be a) Fair and b) Relevant Example: is CPI+x% a relevant and fair balanced fund benchmark? Typical Balanced Benchmark Portfolio with same average Risk-Profile Cash Cash Cash Bonds Average Active Portfolio Equity 10% Bonds Bonds Equity 15% 12% CPI+x% tell us nothing about the skill of the manager! Roland Rousseau – Portfolio Construction Research – November 2013 Equity 16
  17. 17. Conclusion: Chasing skill is never enough Wealth accumulation comes from portfolio efficiency, not chasing past performance.
  18. 18. International Best Practice Bill Miller The Legg Mason Primary Value Fund is one of the most successful active funds in the world and has outperformed the S&P500 for 15 years in a row. Example of Multi-Factor Benchmarking: Dartmouth College lets its students, as part of their education, analyse how much the Legg Mason fund’s return variability comes from value, size and market risk. Their conclusion is: “The high returns are associated with the fund’s extreme exposure to small-cap and value-risk rather than the skill of the manager. The three factors explain all but 8% of the variation in historical returns.” So 92% of the returns’ variability come from just 3 risk-factors! Roland Rousseau – Portfolio Construction Research – November 2013 18
  19. 19. Future of Investment Portfolio Management Harindra de Silva Well-known academic and President of Analytic Investors Inc. This article appeared in the CFA Magazine (Sept-Oct 2006). “Maybe what we’re calling skill really isn’t skill. It may turn out that skill can be partially decomposed into what have come to be called the Fama/French risk factors – the small-cap premium, the value-growth spread, the momentum effect, etc. Discussion may turn to how the excess returns, now attributed to skill, are actually coming from such factors. Then, the question will become whether managers can structure their exposure to such factors better. We may go from a world of [stock picking] to risk allocation! The skill becomes how you build portfolios to exploit the correlations between these factors and how these factors pay-off at different points in time. As shown by beta-risks, returns to risk factors are not a zero-sum game, I hope that repeatable and scalable ways of capturing excess returns can be devised that will prove sustainable and benefit the entire industry.” Roland Rousseau – Portfolio Construction Research – November 2013 19
  20. 20. Conclusion: If you have your money invested in active funds only, you can significantly improve portfolio efficiency by including index funds, without sacrificing any excess returns!
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