Senate group; Why skill is never enough - November 2013

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

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…


2

2

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%



3

“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


4

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!



5

5

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


6

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


7

Part II: Building more efficient portfolios

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


9

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!

10

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

11

‘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


2010

12

2011

2012

2013

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?


13

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


14

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!

15

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!

Equity

16

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

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!


18

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.”


19

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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21

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Senate group; Why skill is never enough - November 2013

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