Alpha in hindsight – the drivers of long-term success
What are the common features of outperforming investment managers? Do market conditions play a role in long-term alpha delivery? To answer these questions we studied the universe of global equity managers from around the globe that had outperformed the MSCI benchmark after fees for the past 20-years ending December 2014. We found that 24 managers out of a total universe of 103 outperformed over this period. On average, these ‘successful’ managers outperformed the MSCI by 2.4% per annum after fees.
These successful managers displayed the types of qualities that Nedgroup Investments focuses on when selecting Best of Breed™ partners. These characteristics are:
- Independence: There is strong evidence that firms that organise themselves sensibly have the best chance of success. Independent, owner-managed firms that focus exclusively on investment management are best structured to deliver the goods, since the appropriate business structures allow firms to better withstand the various pressures that come with unavoidable periods of underperformance. A vital complement to this is material co-investment of principals alongside their clients (preferably on the same, reasonable terms). Independence and the extent of co-investment can be evaluated through ownership organograms, detailed review of business objectives and evidence of the principals’ alignment of interest.
- Long-term focus: To quote Warren Buffet, “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.” Markets in the short-term are generally crowded, competitive and expensive to trade in. To really unlock the value of an investment, patience is required and sometimes a lot thereof. Since it is easy for managers to just state long-term focus as fundamental, you need to review some additional measures as a check. For example, low portfolio turnover suggests that the manager is in fact patient and invested with a ten-year rather than ten-minute plan.
- Valuation-driven Investment philosophy: Value-style managers naturally prefer to select stocks that appear cheap in present space. However, the ability to recognise sustainable growth potential, incorporate it into valuations and strike a balance between value today and value in the future, distinguishes a manager from the ever-growing universe of bottom-up investors. This is one of the toughest things to measure as you need to identify a very specific mind-set. To truly get to grips with a manager’s investment approach and thinking, very detailed research is required. One of the steps in this process should be the reading of past investment commentaries in comparison to the portfolio positioning at the time.
- Emphasis on risk: A portfolio can easily be negatively impacted by unexpected adverse developments in a grouping of shares included (errors of commission), or positive developments in the shares avoided (errors of omission), and consequently end up with poor returns. To reduce the risk of poor performance, a portfolio should be managed with the mentality that multiple outcomes are possible. A portfolio that will produce reasonable returns in most scenarios rather than excellent (or dire) returns in any particular scenario can be expected to deliver much better risk-adjusted returns in the long-run. There are many quantitative risk measures available, but these should never be used in isolation. The risk management tools incorporated in the portfolio construction process and the level of diversification across regions, sectors and stocks are some of the key things to also look at.
We then analysed (using predominately Morningstar® reports) the proportion of successful managers and found that they displayed the characteristics listed above. Our results are illustrated below with a ‘hit-rate’ calculated as the percentage of successful managers for which we found evidence of each feature.
The lowest hit-rate of 71% relates to the number of successful managers that are independent, investment-focused firms. The exceptions here include asset managers that are owned by a bank or are only a sub-division of a much larger conglomerate. This result does not change our view of the great advantages of independence, but rather confirms the importance of digging deeper. In some cases, a sub-division or bank-owned investment team can also operate according to business structures that allow it to be successful.
The two observations for which we could not find the words ‘long-term’ in any of the reports, has an annual portfolio turnover of 37% and 42% respectively. This is a very reasonable level and is perfectly in line with the median of the successful managers of 37%. This finding confirms that there is often much more to a manager than what is included in marketing material, which you will only find thorough research.
We did not delve into the level of detail required to determine whether each of the successful managers possess that specific valuation mind-set we like, but we were pleased to find that the vast majority of successful managers do describe their process as bottom-up.
Lastly, we looked for the mention of diversification and risk management in the philosophy and process descriptions and followed up with the three-year volatility relative to peers quoted in each of the successful managers’ Morningstar© reports. The result was favourable across the board.
Alpha trends in bull and bear markets
Next we studied the proportion of managers that outperformed in different sub-sets of the 20-year period, and the extent of their average annualised alpha in each, and some interesting trends emerged.
The vast majority of the successful managers (green bars of chart below) outperformed in bear markets (orange bars of chart below), as opposed to less than half in bull markets. This result implies that for the successful managers bear markets were thus far more favourable conditions for generating alpha.
Compared to the full period’s average alpha of 2.4% per year, managers delivered four- to five times greater alpha in bear markets as opposed to just keeping up or even underperforming slightly in bull markets. This, again, suggests that bear markets were a key contributor to our narrowed universe’s long-term success.
Knowing for certain which managers will generate long-term alpha without the benefit of hindsight is an impossible task. There is no checklist or set recipe you can follow to guarantee success. There will always be some exceptions, but in-depth and detailed research, as well as special attention to a manager's ability to protect capital in poor market conditions, can greatly increase your chance of success.