Written By: John Arthur
AllenbridgeEpic worked with a number of local authority pension funds on the selection of global equity managers during 2013. John Arthur looks back and takes stock of the key lessons learned
A number of specific issues arose during our recent work on manager selection mandates within global equities. In the last two tenders we have run, we have received over one hundred requests for the documentation once the manager search had been published. The following includes a selection of comments from this recent work.
Pension funds are undoubtedly moving towards awarding broader investment mandates to manage their assets. Regional equity mandates are being replaced by global equities and we are seeing an increased use of diversified growth mandates. This is, in part, being driven by a reappraisal of scheme requirements. The poor investment returns over the last decade have focused attention on how to generate sufficient returns from the assets at an acceptable level of risk.
As little as 10 years ago, the prevailing advice was that the best managers had the best access to company management and that investment ability depended on uncovering information. This was best achieved by those close to the companies on the ground, i.e. regional specialists within equity markets.
Today, the investment edge is less about finding information before other investors and more about analysing and making sense of the mass of publicly available information, then interpreting what is important. Financial information is becoming standardised across geographical regions and thus more easily comparable.
This shift in focus – from information discovery to information filtering and analysis – increases the importance of a manager’s investment philosophy, given that it is this that will dictate what information they see as relevant and how they analyse it.
This broadening of mandates raises a number of questions that are reflected in our approach to manager selection.
First, we are generally supportive of broad investment mandates. In theory, the ability of an active manager to add alpha (outperformance) is mathematically related to the breadth of the investment opportunities they have at their disposal. This, however, assumes their investment philosophy can cope with ever increasing opportunities and the application of ever increasing resources to analyse those opportunities.
For some investment philosophies this is relatively simple. Quantitative investment approaches may be easily scalable from regional to global; the main determinant will be the ability to source the necessary data to conduct the quantitative screens. But what of qualitative investment approaches, where the portfolio is based on the analysis and judgement of a small investment team, perhaps backed by a larger set of analysts?
As always, the line between the two different approaches is not black and white. Whilst a manager may like to call an investment philosophy a quantitative or qualitative approach, it is highly likely that an element of screening is used. At the global equity market level, there are up to 7,000 investable securities, meaning a team of 200 or so analysts to analyse each security in detail. As a result, screening is used to bring this universe of possible investments down to a subset that can be analysed by the resources the manager has available.
The smaller the team managing the assets, the greater the amount of screening that may be necessary to help the fund managers focus their limited resources on those stocks they believe best fit their investment philosophy. We would expect an individual fund manager to struggle to build a strong enough knowledge of a company and its operating environment to develop a high conviction investment decision over more than twenty stocks at any one time.
When researching managers we have always looked at the resources available to the manager and how these are used. With global equity mandates, the way these resources are used to direct the research effort becomes much more important and must fit with the investment philosophy.
A second issue is whether managers can add value by geography or region, as well as through stock selection, when managing global equity money. It was interesting that in our recent manager searches there was no consensus on the answer to this question. Many managers are marketing their stock selection prowess and are, therefore, very reticent about suggesting any other source of alpha. Where a manager did target country, region or sector allocation to add a portion of their alpha they tended to be from the larger houses. These houses already manage multiple asset classes and employ economists and strategists. This multi-layered approach raises the question of who is making the decisions and how the interaction between the different teams is managed.
Global equity markets are sufficiently diverse for major macro trends to be important on occasion. Take the recent 18-month pull-back in emerging markets or the introduction of Abenomics1 in Japan as examples of how a macro-economic issue has dictated equity performance in a particular region over the last few years. If macro-economic and country selection is expected to be a source of alpha there must be a clear decision making and implementation process. All investment decisions must have a clear owner.
Finally, from the client side, moving from a set of regional equity mandates to a global one does alter the structure of a scheme. Whilst previously a pension scheme might employ at least one equity manager in each of five geographical regions, do they want five or more global equity managers? Diversification by manager is a sensible approach but what is the right number of managers? We don’t have any hard and fast rules on this.
In our recent global equity manager searches, the clients wanted active management, and they also recognised the advantage of employing managers running a concentrated portfolio of high conviction positions. However this approach brings significant risk, both in absolute terms and against the benchmark. A concentrated portfolio constructed with limited regard for the benchmark is likely to perform differently from that benchmark, and this performance variation may be greater than the client desires. Consequently, combining two or more managers would seem sensible – but only if they actually offer diversification. If you have too many managers in the same space, the level of diversification may be so great that you end up with benchmark performance whilst paying active management fees! Combining managers with a similar investment philosophy may do little to dampen the volatility of your returns relative to the benchmark, as both managers will perform similarly in similar market environments.
Managers could be combined by looking at past performance and analysing the correlations between each set of managers but, like the analysis of all past performance figures, this only indicates what may happen in the future.
We believe in analysing the investment philosophy first and recognising which approaches are truly differentiated from each other. It is only then that we cross-check past performance to see if the two approaches have produced a string of different returns. As always, this requires long-term data which may not be available. Ultimately we are not looking for a set of managers who are negatively correlated – i.e. in any given quarter one is likely to outperform when the other underperforms. Rather we are looking for managers who are uncorrelated – i.e. the performance of one manager has little or no relationship to the performance of the others.
During our most recent global equity manager search, it was decided that two managers was the appropriate number for the mandate to give diversification by manager and to dampen the volatility of returns against the global equity benchmark. Having agreed with the client a shortlist of five managers for interview, all of whom we believed could fulfil the mandate, we only advised the client of one pairing of managers that we would avoid as we felt the investment philosophy of this pair was sufficiently similar to produce correlated returns into the future. The historic return of the two managers based on quarterly data was high and, more specifically, under periods of market stress had been similar.
When moving from regional to global equity mandates it is important to retain manager diversification. As you are no longer receiving diversification via geography it must be achieved via diversification of the investment philosophy of the underlying managers.
Lastly, I cannot help but conclude that the level of portfolio turnover displayed by many of the managers we reviewed continues to shed a bright and often uncomfortable light on the mismatch between stated investment philosophy and the reality of managing a portfolio. An investment philosophy which requires a high research commitment into analysing the underlying securities takes time. It will take an analyst some months to build up their knowledge of a company’s operating environment. This sits uncomfortably with a holding period of just six months or so for shares in the portfolio, yet this was often the case.
1. Economic measures consisting of quantitive easing, fiscal stimulus and structural reform introduced by Shinzo Abe after his 2012 re-election to the post of prime minister in Japan
The views expressed in this article are those of the author and do not necessarily represent those of AllenbridgeEpic Investment Advisers.
Nothing contained herein constitutes any form of investment advice or a personal recommendation to buy or sell any security nor should it be relied upon as such. You should consult your own advisers before considering taking any action based on this article.
AllenbridgeEpic Investment Advisers Limited is an appointed representative of Allenbridge Capital Limited which is Authorised and Regulated by the Financial Conduct Authority.