Total investment return outcomes are driven by market exposure as well as (potential) alpha.
Strong investment markets help to deliver outcomes that meet investor return expectations.
Alpha, the value added by skilful active investment management in addition to relevant market exposure, is useful in expanding these return outcomes, especially so when market returns are lower or more volatile.
True alpha is rare and difficult to produce.
The fundamental law of portfolio management formally tells us that successful active investment management depends (essentially) on two ingredients: investment management skill and the opportunity to use that skill.
This may appear a trivial statement of fact, but it has far reaching implications for the construction of investment products and their aggregation into client portfolios.
Skill without opportunity is unrewarded. Skill applied in a constrained opportunity set leads to sub-optimal outcomes.
For a skilled investment professional, superior outcomes result by applying that skill in the broadest possible opportunity set.
The trouble with traditional investment mandates
The challenge is that traditional investment management arrangements typically constrain the opportunity set.
One constraint, for example, is the ‘long-only’ constraint usually imposed in traditional equity mandates, which prevents the manager from taking short positions, where a security is sold beyond its weight in the relevant index.
Adopting short positions can be risky. When short, the manager benefits from a fall in the price of the security but will be hurt if the security price increases — effectively the opposite of being long.
The long-only constraint, however, prevents short positions and creates an asymmetry in the investment manager’s ability to apply skill, as the manager cannot take advantage of extreme negative views.
For example, if a long-only constrained investment mandate allows the manager to adopt relative positions within a 5 per cent band for each security, then for a security representing 2 per cent of the index, the maximum underweight is 2 per cent (that is, zero per cent total portfolio exposure to the security), but the maximum overweight is 5 per cent (that is, 7 per cent total exposure). This leads to a sub-optimal payoff for active risk.
Active extension
Until recently, the ability to effectively use the additional opportunity afforded by removing the long-only constraint in portfolio construction and allowing short positions has been the domain of hedge fund managers.
Many traditional managers are adopting these and other hedge fund ideas in order to expand the opportunity set for the application of active investment management skill, and therefore deliver superior outcomes to investors through ‘active extension’ products such as 130/30 or long-short equity products.
What is 130/30?
The basis for a 130/30 (130 per cent long, 30 per cent short) portfolio is the short sale of securities, the proceeds of which are re-invested in the expected outperformers (long part of the portfolio).
This is illustrated in the graph, which compares the security weight in the portfolio under a typical long-only constrained arrangement and a 130/30 arrangement.
The key point to note here is the expansion of long holdings and the introduction of offsetting short positions. These result in an expansion of the overall gross active risk adopted by the manager while retaining an overall net market exposure of 100 per cent.
This approach provides a greater opportunity set to the manager and, for investors, leverage to the manager’s skill without leveraging capital.
This style of product has some advantages over less constrained hedge fund products: with a net market exposure of 100 per cent, client portfolio fit can be more easily addressed, and it carries less of the risks typically associated with hedge funds, such as liquidity and transparency.
Not just the domain of the active quantitative investment managers
Long-short strategies have been employed successfully in hedge fund structures for many years and, with the migration of hedge fund investment techniques into the mainstream (as part of a broader convergence between these two parts of the industry), more recently by active quantitative investment managers.
The appetite for active extension in the quant space is understandable given the desire for risk control and portfolio construction focus when introducing non-traditional investment techniques.
It needs to be noted, however, that quant is only one potential style of active investment management skill and alpha. Importantly, the approach outlined here is equally applicable to other fundamental investment processes.
What is clear is that, where there is conviction in the fund manager, that conviction is best rewarded by providing a greater opportunity set.
Indeed, a number of funds management businesses have already begun to realign to this new environment, ensuring the retention of the very best investment talent and incorporating a range of alternative investment strategies, thinking and processes in the expansion of the investment opportunity set.
Where to from here?
For investors and their advisers seeking superior investment outcomes, the way forward is clear:
> manager selection needs to continue to focus on the identification of true investment management skill; and
> product selection needs to ensure a greater opportunity set for the application of investment management skill. For an equities product, this may mean a 130/30 extension.
As a further component, advisers should look at the resources, mandate and financial backing devoted to ongoing development.
The truly successful fund managers of the future will be those that have a dedicated development engine that is strongly mandated across asset classes and able to allocate funds to support development activities including incubation and seeding.
These activities need to encompass the development of new capabilities within the pool of investment talent, such as the skill required for shorting or using other non-traditional investment techniques, as well as the delivery to market of new higher-return seeking products.
This focus provides the additional benefit of ensuring integrity and continual development of the existing product suite.
Dr Joe Fernandes is the head of the global investment solutions group within ColonialFirstStateGlobal Asset Management .
