Asset allocation and the search for alpha

But what are the factors that govern when and where to use them? Asset allocation decisions are influenced by a variety of factors including the relative costs and fees of active and passive vehicles in various asset classes, whether any risk limits apply to the fund, and where alpha - or outperformance - can be found for the right price.

There are several considerations which are key to building and managing a blended investment portfolio which aims to deliver good risk-adjusted returns at a reasonable price.

One is whether or not the environment is conducive to active management. “Environment” here includes the region or asset class you are considering investing in, as well as the time that you are making your decision.

For instance, US equity markets are often considered the most efficient in the world, making outperformance difficult, which is supportive of passive investment. Research by Standard & Poor’s shows that in the 12 months to June this year, 59.78% of large-cap fund managers underperformed the US S&P 500 index. And, the rate of underperformance tends to rise over longer periods. In the three years to June 2014 54.94% of large-cap firms underperformed the S&P 500 Index, while in the five year period to June the underperformance rate remained high at 85.92%. Similarly, from an asset class perspective, government bond markets are also difficult to gain outperformance against, so again, many investors choose not to pay up for active funds in this space.

However, while outperforming either the US equity or UK gilt markets may be difficult, it’s not impossible. Through thorough research and by closely following the wider macro environment, windows of opportunity can be identified in which better than market average returns may be achieved by active management.

The timing of significant events and their potential impact on the markets and investment portfolios is another key consideration and should be at the forefront of anyinvestment management decisions.

A recent example of how timing of significant events can impact fund management decisions was the “risk on, risk off” environment that prevailed around the time of the Eurozone crisis between 2011 and 2013. With so much uncertainty around the longevity of the Eurozone union in its existing form, the overall market environment was driven more on a daily basis dependent on whether economic data or political conferences were occurring and what new information they yielded on any given day, rather than byeach individual company’s own fundamentals.

In this period there was little alpha to be found: active managers struggled to outperform market indices, so investors wanting to maintain exposures were better served by doing so cheaply through index trackers. As we moved out of that environment, though,it was revealed that opportunities had been created for stock pickers to exploit, and the pendulum swung the other way: it became potentially worth it to pay up for active managers.

Passive investing is popular not only for those that believe markets are efficient but also because it can be cost-effective, with lower fees comparative to active investment options. The search for alpha does come at a cost. But investors need to consider the relative costs of alpha across asset classes, especially in a cost-controlled environment. Whereas mainstream equity and fixed income passive funds cost roughly the same, active equity funds can be almost twice as expensive as active bond funds. But is there twice as much alpha available in the equity space?

There is no universally accepted answer to this question, so it leads to the second quandary facing investors building blended portfolios – where to deploy a limited budget in the pursuit of outperformance.

Another area an investment manager must consider regarding asset allocation and the possibility of market outperformance – or not – is whether he wishes to express a style bet in the portfolio. The most commonly referred to styles in equity investing are growth and value.

Growth managers try to determine how much a company can grow given its fundamentals and the economic backdrop, and then decide how much they are willing to pay for that potential growth. Value managers approach the problem from the other side, determining how much they are prepared to pay to own a portion of the company’s assets. Other styles include quality growth or income. Style can have a significant impact on returns in both the short and the long term, so it is important to have a view on style, or at least to be aware of any style tilts within a portfolio.

Options for introducing a particular management style are limited with passive vehicles. While there are some trackers built around style factors, they tend to be priced mid-way between active funds and “plain vanilla” trackers. That means they lose much of the cost advantage that trackers can provide. Meanwhile, active managers, although more expensive, can deliver more focused exposure to a particular style tilt.

These are among the more important factors that need to be considered and researched to build a well-balanced investment portfolio which aims to achieve good performance at a reasonable cost. There is no single way to achieve this, but knowledge and understanding of as many variables and details as possible should help avoid some of the potential pitfalls.

Sheldon MacDonald is Senior Investment Officer at Architas