EVALUATING OPPORTUNITIES IN ACTIVE MANAGEMENT

Transcription

1 RESEARCH INSIGHT EVALUATING OPPORTUNITIES IN ACTIVE MANAGEMENT Abhishek Gupta, Raina Oberoi, Raman Aylur Subramanian May 2018 MAY 2018

2 CONTENTS Executive Summary... 3 Introduction... 4 Analyzing Market Opportunity for Active Managers... 5 Analyzing the Skills of Active Managers... 9 Conclusion References MSCI.COM PAGE 2 OF 16

3 EXECUTIVE SUMMARY Institutional investors typically select active managers who have historically delivered superior risk-adjusted performance on a consistent basis. One way to select managers is by segregating them based on the region of their investment focus U.S. large caps, U.S. small caps, international large caps, global small caps and emerging markets and then reviewing the value added by active managers in these markets. We studied key attributes of these markets and concluded that not all markets are created equal. Some markets are less efficient than others, while some exhibit a higher dispersion of returns. These are two important considerations when evaluating the breadth and depth of opportunities available for active management in a given market. We found that both emerging markets and small caps were relatively less efficient and exhibited higher return dispersion than other market segments, thereby creating a dynamic pool of potential opportunities for active management. In addition, a review of past performance showed that active managers have indeed been more successful in emerging markets and small caps. Within small caps, international smallcap managers performed better than U.S. small-cap managers. In contrast, U.S. large-cap active managers faced headwinds with deteriorating performance since More importantly, performance persistence, i.e., the ability to consistently deliver superior performance, was lower in U.S. large-cap and international large-cap segments than for small caps and emerging markets. Active management has been more attractive in emerging markets and small caps than in other markets. With the increase in global allocations, these regions may present exciting avenues for active managers who are looking to add further value for institutional investors. MSCI.COM PAGE 3 OF 16

4 INTRODUCTION The rules-based transparent approach and cost efficiency of passive management are key attributes driving institutional investors globally to continue allocating funds to such strategies. However, active management remains attractive across various products and geographies. A detailed review of the opportunities available for active management can provide useful insights for the investment community. To illustrate this, we analyze different segments of the equity markets and highlight the value active managers have added in each case. Success in active management is a complex interaction of two dimensions market opportunity and manager skill. Active managers have wide ranging skill levels and different markets offer different levels of opportunity for active managers to outperform their peers and the market in general. Before committing capital to active management, an institutional investor would likely assess the breadth of opportunities in different segments of the equity markets and the skill of active managers operating in those segments. The ability to select skilled managers in opportune markets, who can add value beyond a passive investment tracking an index, may justify the case for active implementation. Market opportunity, the first dimension, is directly linked to the efficiency of the market under consideration. An inefficient market, characterized by low liquidity, mispriced securities and higher return dispersion, provides fertile ground for actively selecting securities. High-conviction skilled managers pursuing alpha-generating strategies in such markets have been able to differentiate their performance more strongly than when operating in efficient markets (Gorman et al., 2010). Manager skill, the second dimension, relates to the ability of an active manager to accurately identify mispriced securities and factor-allocation or market-timing opportunities, and to leverage market volatility to outperform peers. Skilled managers have been better able to forecast asset returns than low-skilled managers (Grinold and Kahn, 2000). In order to test the validity of the notion that analyzing market opportunity and manager skills can be equally important considerations when making active allocation decisions, we evaluate these dimensions across different segments of equity markets for the period Dec. 1, 2005 to Dec. 1, For this purpose, we consider U.S. large-cap, international large-cap, global small-cap and emerging market equities, as represented by the MSCI USA Index, MSCI World ex USA Index, MSCI World Small Cap Index and the MSCI Emerging Markets Investable Market Index (IMI), respectively. 1 This classification broadly represents the equity 1 International refers to all developed market countries with the exception of the U.S., whereas global comprises both U.S. as well as international segment countries. MSCI.COM PAGE 4 OF 16

5 allocation structure of most global institutional investors (see The New Classic Equity Allocation?, Kang et al., 2010). ANALYZING MARKET OPPORTUNITY FOR ACTIVE MANAGERS One way to measure the first dimension of active management success market opportunity is to evaluate the relative accessibility and liquidity of different equity markets. Markets with low accessibility and liquidity are generally mispriced, and investors are compensated for this illiquidity (Amihud, 2002). This provides greater opportunity for active managers. Institutional investors would thus ideally compare the relative efficiency of different markets when determining where to allocate assets to active strategies. As shown in Exhibit 1, emerging-market and small-cap companies exhibited lower accessibility and liquidity characteristics than others. Average float, representing the proportion of shares accessible to international investors, has been lowest in emerging markets. As a measure for liquidity, MSCI employs the annualized traded value ratio (ATVR). 2 The lower the ATVR, the less liquid is the security. Nearly 30% of emerging-market companies and 18% of small-cap companies had ATVRs lower than 50% as of December While MSCI Indexes are designed to be investable and replicable through the use of liquidity screens, these levels of liquidity have offered greater opportunity for outperformance through stock selection. In comparison, U.S. and international large-cap stocks were much more liquid with higher float, higher ATVR and higher frequency of trading. 3 2 ATVR is computed as follows. First, monthly median traded values are computed as the median daily traded value multiplied by the number of days in the month that the security traded. The daily traded value of a security is equal to the number of shares traded during the day multiplied by the closing price of that security. Second, the monthly median traded value of a security is divided by its free-float-adjusted security market capitalization at the end of the month, giving the monthly median traded value ratio. Finally, the 12-month ATVR is obtained by taking the average of the monthly median traded value ratios of the previous 12 months or the number of months for which this data is available (previous 6 months, 3 months or 1 month) and annualizing it by multiplying by The 3-month frequency of trading is determined by dividing the number of days a security traded during a 3-month period by the number of trading days within this period. MSCI.COM PAGE 5 OF 16

6 Exhibit 1: Accessibility and Liquidity in Different Equity Markets Source: MSCI, December 2017 Another way to measure opportunity for active management is cross-sectional return dispersion, calculated as the standard deviation of asset returns over a single period. If the dispersion of stock returns is very small, then all stocks behave similarly and there is little opportunity for active managers to outperform the market through stock selection. Conversely, when cross sectional volatility levels are high, this presents more opportunities for stock selection, and performance differences among active managers are more pronounced (Ankrim and Ding, 2002, Menchero and Morozov, 2011). Exhibit 2 illustrates the empirical relationship between cross-sectional volatility and the spread in active management performance across different equity markets. MSCI.COM PAGE 6 OF 16

7 Exhibit 2: Cross-sectional Volatility vs. Manager Dispersion Across Different Equity Markets Source: MSCI, evestment Alliance, December 2005 to December Cross-sectional volatility calculated for securities in MSCI USA, MSCI World ex-usa, MSCI World Small Caps and MSCI Emerging Markets Indexes. The corresponding manager dispersions are calculated across evestment active equity core funds focusing on U.S. large caps, global ex-u.s. large caps, global small caps and emerging markets. Manager dispersions are calculated as the difference in absolute monthly returns between the 95 th and 5 th percentile manager. Global ex-u.s. large caps comprises funds having a global geographic focus and may thus have incidental allocation to emerging markets. Global small caps includes all U.S. and developed market small-cap funds. Emerging markets include large-, mid- and small-cap funds. Given that cross-sectional dispersion of returns accentuated active outperformance, institutional investors could have ideally examined and compared different segments of the equity markets in search of greater active management opportunities. Exhibit 3 shows that on a relative basis, global small caps and emerging markets (albeit to a lesser degree) structurally exhibited higher return dispersion than U.S. and international large caps, thus offering greater potential for active management. MSCI.COM PAGE 7 OF 16

8 Exhibit 3: Cross Sectional Volatility in Different Equity Markets Source: MSCI. Cross-sectional volatility averaged over 12-month trailing period, December 2005 to December Based on volatility contributions, cross sectional volatility can be attributed to different sources of risk country, industry, style (factors) and specific risk. This may help investors identify which risk groups present potential opportunities for active management. While country, industry and style (factors) are designed to capture systematic sources of risk prevalent in markets, specific risk represents that associated with the selection of securities. Exhibit 4 examines the relative importance of these risk groups across different equity markets. For active managers focused on emerging markets, country selection or country timing has provided significantly higher opportunity for outperformance. Likewise, industry allocations were related to the higher return dispersion among U.S. large caps relative to other markets and provided greater opportunities for active management within this risk group. While security selection was most relevant in the small-cap segment (high specific risk contribution), over the last few years, style (factors) has contributed to similar levels of volatility across all markets. MSCI.COM PAGE 8 OF 16

9 Exhibit 4: Absolute Volatility Contributions in Different Equity Markets Source: MSCI, December 2005 to December Cross-sectional volatility contributions are calculated using the MSCI Barra USSLOW model for MSCI USA, MSCI Barra GEMLT model for MSCI World ex USA and MSCI World Small Cap, and MSCI Barra EMM1 model for MSCI EM. ANALYZING THE SKILLS OF ACTIVE MANAGERS Analyzing the second dimension of active management success manager skill requires significant understanding of their investment processes and investment decisions. For the sake of simplicity, in this research we use historical manager performance as a proxy for skill. Specifically, we use empirical performance data from the evestment Alliance database, which contains self-reported manager information and captures a substantial sample of institutional mandates. From this database, we select core active equity managers with AUM greater than $100m, and classify them by their geographic and market capitalization investment focus U.S. large caps, international large caps, global small caps and emerging market equities. 4 We evaluate and compare the value added by active managers in each of 4 Global ex-us Large Caps comprises funds having a global geographic focus and may thus have incidental allocation to emerging markets. Global Small Caps includes all US and developed market small cap funds. Emerging markets include large-, mid- and small-cap funds. MSCI.COM PAGE 9 OF 16

10 these segments from 2008 to All performance statistics are calculated relative to benchmarks reported by managers and are gross of management fees. Exhibit 5 shows that the percentage of U.S. large-cap active managers outperforming their benchmarks declined sharply over time and was the lowest among all manager groups. A median U.S. large-cap active manager was unable to add risk-adjusted active return (the ratio of active returns to tracking error, or information ratio) for three-year periods ending in 2011, 2014 and International large-cap managers also saw a moderate drop in overall performance with information ratio declining over time. Global small-cap and emerging markets active managers, in contrast, were much more successful and consistently delivered either similar or better performance compared to A one-year rolling analysis with three-year trailing history showed similar outcomes. Exhibit 5: Performance of Active Managers in Different Equity Markets Source: MSCI, evestment Alliance. Information ratio based on trailing three-year performance using manager preferred benchmark. Analysis for 12 years ending Dec. 31, 2017, divided into four three-year periods. Breaking down information ratio into its components provides further insights. The slide in information ratio in U.S. and international large-cap segments was led by a decline in active returns in these segments over the last 12 years (see Exhibit 6). Active returns were either similar or higher in emerging markets and global small caps. Tracking error also systematically declined across all markets and capitalization segments since 2008, indicating a scarcity of active opportunities in the market. This was corroborated by an overall decline in cross-sectional volatility in these markets since 2008, as shown earlier in Exhibit 3. Tracking error, however, remained higher in emerging markets and small 5 We selected the period beginning in 2008 to coincide with significant outflows that actively managed equity mutual funds experienced at the expense of indexed funds and ETFs since that time (Investment Company Industry Fact Book, 2017). MSCI.COM PAGE 10 OF 16

11 caps, and declined least in emerging markets. Interestingly, over the last three years ( ), even though tracking error increased broadly across all segments, active returns declined. This highlighted a challenging environment for security selection during the period. Exhibit 6: Active Returns and Tracking Error of Active Managers in Different Equity Markets Source: MSCI, evestment Alliance. Active return and tracking error based on trailing three-year performance using manager preferred benchmark. Decomposing global small caps into U.S. and international small caps, we see that active management success was much more limited in U.S. small caps (see Exhibit 7). Additionally, tracking error was consistently higher for these managers, highlighting their larger active decisions. However, higher tracking error was not always rewarded, leading to a significantly lower information ratio for U.S. small-cap managers for the three-year periods ending 2014 and Exhibit 7: Performance of U.S. and International Small Caps Source: MSCI, evestment Alliance. Tracking error & information ratio based on trailing three-year performance using manager preferred benchmark. Since the number of global small cap managers was limited in 2008, the analysis starts in 2011 and runs over the subsequent two three-year periods. MSCI.COM PAGE 11 OF 16

12 Exhibit 8 shows the spread between the performance of top- and bottom-quartile managers across different equity segments. It indicates that manager performance dispersion has declined across U.S. and international large caps and global small caps, a result consistent with the lower stock return dispersions in these segments. On the other hand, emergingmarket managers demonstrated consistent performance dispersion, outlining the continued success that top-quartile managers had over bottom quartile managers in those markets. Exhibit 8: Performance Dispersion of Top- and Bottom-quartile Active Managers Source: MSCI, evestment Alliance. Manager performance dispersion is measured as the gap between the median information ratio of the top- and bottom-quartile managers. Of course, it is important to distinguish skill from luck. Selecting outperforming managers does not necessarily guarantee future success, as the performance of managers may not persist. Exhibit 9 shows the proportion of active managers that ranked in the top quartile in the first three-year period and continued to achieve above median performance over the subsequent three-year periods. Both U.S. and international large-cap managers demonstrated weak performance persistence, with only a small proportion of the top quartile managers in 2008 remaining above median in each of the subsequent three-year periods (while a greater proportion have fallen below the median). Reversal, on the contrary, was much stronger than persistence, with a much higher proportion of managers jumping from bottom quartile in 2008 to above median in the subsequent three-year periods. Since the numbers of global small-cap and emerging markets managers were limited in 2008, the analysis start date is set at 2011 for these equity segments. Global small-cap and emerging-markets managers exhibited stronger persistence and weaker reversal, compared to U.S. and international large-cap managers over three-year periods. MSCI.COM PAGE 12 OF 16

13 Exhibit 9: Performance Persistence and Reversal of Active Managers in Different Equity Markets Source: MSCI, evestment Alliance. Persistence indicates the proportion of top-quartile managers in 2008 that remained above median in the subsequent three-year periods. Reversal indicates the proportion of bottom-quartile managers in 2008 that jumped to above median in the subsequent three-year periods. Results have not been adjusted for potential biases, such as survivorship bias and selection bias. CONCLUSION We analyzed different segments of the equity markets in terms of their accessibility, liquidity and cross-sectional return dispersion. We observed that international small caps and emerging markets offered greater opportunity for active stock selection compared to the U.S. and international large-cap equity segments. This was also reflected in their performance. While U.S. large- and small-cap, as well as international large-cap active managers have struggled to add value over their benchmarks, active managers focusing on international small caps and emerging markets were much more successful in delivering consistent performance over time. This insight can be useful to institutional investors who are looking to make global allocations and are evaluating both active and passive management. It can also be helpful to active managers who are looking to create differentiated products globally. MSCI.COM PAGE 13 OF 16

14 REFERENCES Allen, G.C. (2005). The Active Management Premium in Small-Cap U.S. Equities. Journal of Portfolio Management, Vol. 31, No. 3, pp Amihud, Y. (2002). Illiquidity and Stock Returns: Cross-Section and Time-Series Effects. Journal of Financial Markets, Vol. 5, No. 1, pp Ankrim, E. M. and Z. Ding. (2002). Cross-Sectional Volatility and Return Dispersion. Financial Analysts Journal, Vol. 58, No. 5, pp Carhart, M. (1997). On Persistence in Mutual Fund Performance. The Journal of Finance, Vol. 52, No.1, pp Fama, E.F. and K.R. French. (2010). Luck versus Skill in the Cross-Section of Mutual Fund Returns. Journal of Finance, Vol. 65, No.5, pp Gorman, L.R., S. Sapra and R. Weigand. (2010). The Cross-Sectional Dispersion of Stock Returns, Alpha and the Information Ratio. Journal of Investing, Vol. 19, No. 3, pp Grinold, R.C. and R.N. Kahn. (2000). Active Portfolio Management. McGraw-Hill. Kang, X., F. Nielsen and G. Fachinotti. (2011). Some Like It Hot. MSCI Barra Research Insight. Kang, X., F. Nielsen and G. Fachinotti. (2010). The New Classic Equity Allocation? MSCI Research Insight. Knutzen, E. (2010). Revisiting the Active vs. Passive Decision. NEPC Research. Menchero, J. and A. Morozov. (2011). Decomposing Global Equity Cross-Sectional Volatility. Financial Analysts Journal, Vol. 67, No. 5, pp Urwin, R. (2000). Avoiding Disappointment in Investment Manager Selection. Watson Wyatt. MSCI.COM PAGE 14 OF 16

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