RBC Global Asset Management provides a strong case for the opportunity of active management and its role within a truly diversified portfolio.
As they note, there are considerable opportunities within markets for active managers to turn into reliable excess returns.
RBC’s analysis highlights that a large proportion of active share price movements, up to 75%, cannot be explained by market factors.
This is a large opportunity set for active managers. An opportunity set that is found to remain reasonably consistent over time.
The scale of the opportunity as demonstrated by RBC, if successfully captured, provides a potential source of excess returns and a true portfolio diversifier – which is a return outcome largely sourced from company/stock specific risks.
Nevertheless, active managers do need to evolve from historical practices and processes. From this perspective, the paper also provides great insights into the evaluation of a modern day active manager.
With regards to the success of active management, the Conventional Wisdom toward active management is changing. Specifically, the conventional wisdom is too negative on the value of active management.
The RBC article is well worth reading.
RBC emphasis “An active manager’s task is to capitalise on the fact that the market or index return is an average, and to use analysis and skill to identify those stocks that produce an above-average return and to avoid those that don’t.”
To capture the opportunity identified by RBC, they believe active managers need to find a way to turn share price movements into reliable excess returns.
To do this they believe that active managers must get two things right:
- Alpha generation: devise means of explaining and predicting the share price movements that are not explained by factors.
- Alpha capture: devise means of efficiently capturing alpha and turning it into reliable portfolio excess returns.
The RBC paper provides a lengthy discussion on what it likely takes to achieve this, including analysing the unique features associated with each business, including ESG factors, taking an active ownership role, and maintaining a long-term perspective.
Each company (security) has a unique performance history, which cannot all be explained by broad market factors. Financial outcomes are partly dependent on management teams, brand, location, reputation, non-financial factors, and Culture. Analysis needs to be undertaken on the unique factors associated with each business.
Furthermore, accounting data is a poor measure of business value, there are extra financial factors, Governance, employee engagement, Health and Safety, ESG etc etc
RBC conclude “that the critical skill for stock pickers is understanding and evaluating extra-financial factors as well as assessing their impact on financial returns. Skill and expertise need to be developed to assess nuanced factors such as corporate culture, employee engagement, customer satisfaction, the business’s social licence to operate, maintenance and safety procedures, R&D effectiveness, brand and reputation, and these will vary from industry to industry and will also shift over time.”
See the article for fuller discussion on their perspective and type of analysis required by a modern day active manager.
Portfolio construction is also key, the size of portfolio positions matters.
Equity investments can be held in fractional holdings so it is possible to construct an almost infinite number of portfolios from a relatively modest number of securities.
Different combinations of securities will create portfolios with different factor exposures. Which will cause variation in portfolio returns.
Therefore, Portfolio construction becomes the framework within which portfolio managers can assess the trade-off between “two often conflicting objectives: maximising exposure to their best investments vs. minimising exposure to unintended factor returns.“
My personal view is that many managers under estimate the value added from a solid portfolio construction approach, often it distracts value from a sound stock selection process.
One final point, the paper provides a good account of how active management has been disrupted by technology and the information revolution – computing power and access to company information. This has resulted in the rise of passive investing and factor-based investing. This has driven down fees.
The active management industry has changed dramatically, and active management has had to evolve. This is touched on within the Article.
Therefore, the Article provides insight from the perspective of manager selection and a potential lens with which to consider in evaluating modern day active managers.
The Role of Active management within a portfolio
From a Kiwi Investor Blog perspective, the active management described by RBC in the Paper “seeks to generate outperformance from stock-specific risk that lies outside the realms of factors. This is a different alpha source, hence it creates a return stream that is not correlated to factor returns.”, highlights the role active management can play within a truly diversified and robust portfolio.
Consistent with RBC, active managers can co-exist with passive and factor based strategies. Active management has a role to play within a Portfolio.
Why? Investors seek to access a wide range of investment risks and returns, seeking true portfolio diversification.
The source of risks and returns from active management that seeks to outperform from stock specific risks is a true portfolio diversifier, if done successfully.
This is consistent with many Posts on Kiwi Investor Blog around the disaggregation of investment returns.
Understanding the disaggregation of investment returns can assist in building a truly diversified and robust portfolio.
It can also help determine the appropriateness of fees being paid and if a manager is adding value.
Many institutional investors understand that true portfolio diversification does not come from investing in many different asset classes but comes from investing in different risk and return sources. See earlier post More Asset Classes Does not Equal More Diversification.
The objective is to implement a portfolio with exposures to a broad set of different return and risk outcomes. For example, the increasing allocation to alternative investment strategies by institutional investors globally, such as hedge fund strategies, to complement more traditional investments is evidence of this.
Essentially, and from a very broad view, investment returns can be disaggregated in to the following three parts:
- Market beta. Think equity market exposure NZX50 or S&P 500 indices (New Zealand and America equity market exposures respectively).
- Factor and Alternative hedge fund beta exposures. See the Disaggregation of Investment Returns Post for a fuller discussion.
- Alpha. Alpha is what is left after beta and factors. It is the manager skill to capture the stock specific risks as outlined in RBC paper. Alpha is a risk adjusted return source.
With regards to the success of active management, the Conventional Wisdom toward active management is changing, as highlighted in this Post. The linked article in this Post is the most read from Kiwi Investor Blog.
The article undertakes a review of the most recent academic literature on active equity management and concludes by challenging the conventional wisdom of active management, “taken as a whole, our review of current academic literature suggests that the conventional wisdom is too negative on the value of active management.
Finally, the disaggregation of investment returns busts opens the active vs passive debate, the debate has moved on. It is no longer an emotive black vs white debate, risk and return sources come in many different shades. A truly diversified portfolio has as many different risk and return exposure as possible. It is from poor portfolio construction that portfolios fail. The value is in implementation of a truly diversified portfolio.
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