Senate group; Why skill is never enough - November 2013

Roland Rousseau – Portfolio Construction Research – November 2013 1

How to build better investment portfolios without skill

Roland Rousseau Quantitative Portfolio Construction Research

Why Chasing Skill

is Never Enough!


What do Investors Really, Really Need?

2

Do we need skill-based performance?

They need an excess return (e.g. above inflation, benchmark, liabilities etc)

Investors need a return that covers or exceeds their opportunity cost of not investing

They need a positive return after costs

They need a return without excessive ‘risk’

Acceptable Costs

Excess Return

Tolerable Risk

Value for Money

Is skill-based performance Necessary and Sufficient to achieve your investment goals?

Let’s see…


What Returns can we expect without skill?

Portfolio Weights and Returns (pa) since 1985

Source: Barclays, ABSA Capital, Inet

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%


Long-Term Portfolio Returns

for different Equity Allocations

15.3% 15.6%

15.9% 16.1%

16.2% 16.6%

20% 30% 40% 50% 60% 70%

CPI Inflation (pa) since 1985

8,4%


“Mommy, where do Excess Returns come from?”

±

Return = risk free rate + + uncorrelated excess skill from fund manager

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

10% = 2% 7% 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


Are we using the right benchmarks?

5

Higher Risk = Higher Return, regardless of skill

What are the odds of choosing a portfolio with a return higher than eg. CPI+5%?

Equal weight (ie no skill)

Sa

me

ris

k


Higher Risk = Higher Return without skill!


Battle of the Giants: Allan Gray vs. Coronation Compound Performances are very misleading

0

200

400

600

800

1000

1200

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

30% Bonds 65% Equity 5% Cash

Allan Gray Balanced Fund

Coronation Balanced Fund

CPI+7%

CPI

Source: Barclays, ABSA Capital, Inet, Morningstar


Relative Performances are more informative Relative to arbitrary Balanced Fund: 30% Bonds + 65% Equity + 5% Cash

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Allan Gray Balanced Fund relative performance

Coronation Balanced Fund relative performance

Source: Barclays, ABSA Capital, Inet, Morningstar

Part II: Building more efficient portfolios


Building more efficient forecasts

YOUR INVESTMENT

CHOICE

Memorable (invest more efficiently)

• Fair and relevant benchmarks

• Focus on active – risk (beta)

• Only pay for real skill

Average (invest like everyone else)

• Use inconsistent benchmarks

• Focus on active –return (alpha)

• Chase past performance


Getting the Basics Right first …

STEP 3: Manage risk actively within core portfolio

STEP 2: Invest in low-cost core portfolio (i.e. passive)

STEP 4: Choose active funds that deliver true skill (not risk that is disguised as skill)

STEP 1: Choose a long-term, strategic, risk-profile for your client (asset allocation)

Watch this space!


Risk-Factor eg currency, interest rates

Ret

urn

Qu

alit

y, a

bili

ty t

o ’p

red

ict/

mo

de

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Risk-Factors - 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 - Momentum - Price Reversals - Earnings surprises/revisions

Risk-Premium eg. equity, value, momentum, small caps, emerging mkts

Outperformance without active skill!! But Risk-Premia are risky (eg Value)!

Risks are valuable sources of returns!


0

100

200

300

400

500

600

700

800

900

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Super Duper Fund X

FTSE/JSE ALSI (J203T)

‘Value’ Risk Premium using DY

21% pa

16% pa

FTSE/JSE Div+ Index (J259T) 30 highest DY stocks


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

Top 20 General Equity Funds (3 years)

Source: Morningstar

167 General Equity Funds over period

FTSE/JSE ALSI ranked 30/167 (82%)

FTSE/JSE SWIX ranked 24/167 (86%)

FTSE/JSE Eq. weighted Top 40 8/167 (95%)

FTSE/JSE Div+ ranked 1/167 (100%)

Inconvenient Facts and Truths

Why are investors not being told about low-cost, high performance, index funds?

SA Benchmarking Issues: Peer Group Surveys

We always chase the Top Managers

FTSE/JSE Top 40 ranked 34/167 (80%)

FTSE/JSE RAFI ranked 28/167 (83%)


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?

How can we beat the FTSE100 without skill?

How can we beat the MSCI World Index without skill?

Overweight value stocks or small caps – VRP 3-5%pa

Overweight Emerging Markets – EMRP 2-5% pa

Overweight Equities – ERP 3-6% pa

Indices and CPI are not Benchmarks!


Risks are out of our control/influence!

2 tons per hectare

Ben

4 tons per hectare

Roy Which farmer

is better?

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!


SA Benchmarking Problems: Beware CPI Benchmarks

EquityBonds

Cash

Typical Balanced Benchmark

10%

Average Active Portfolio

15%

EquityBonds

Cash

Good Benchmarks need to be a) Fair and b) Relevant Example: is CPI+x% a relevant and fair balanced fund benchmark?

Portfolio with same average Risk-Profile

12%

EquityBonds

Cash

CPI+x% tell us nothing about the skill of the manager!

Conclusion: Chasing skill is never enough Wealth accumulation comes from portfolio efficiency, not chasing past performance.


International Best Practice

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!

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.


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.”

Harindra de Silva Well-known academic and President of Analytic Investors Inc.

Future of Investment Portfolio Management

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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Senate group; Why skill is never enough - November 2013

Economy & Finance

Transcript of Senate group; Why skill is never enough - November 2013