BUILDING EQUITY PORTFOLIOS WITH STYLE JULY 2014

Transcription

1 BUILDING EQUITY PORTFOLIOS WITH STYLE JULY 2014

2 WE BELIEVE THAT IT IS IMPORTANT TO FOCUS ON THE UNDERLYING DRIVERS OF RETURN 2

3 INTRODUCTION Much has been written recently about smart beta, advanced beta, intelligent indexing, and various other buzzwords broad terms that are not always well-defined. Looking beneath these catchy titles, Mercer believes that it is important to focus on the underlying drivers of return and how this can help investors with constructing and monitoring their portfolios. We have been helping clients implement equity structures with explicit allocations to style factors for many years. This short paper serves as a primer on approaches to capturing a range of return drivers in global equity portfolios. WHAT DRIVES EQUITY RETURNS? The first step is to consider what it is that drives equity returns and which of these factors investors should emphasise in portfolios. There are many factors that can affect returns. Historically, investors think in terms of a top-down framework, such as one defined by geography, industry sector, or market capitalisation. Of course, these factors can still affect returns we saw that in 2013 when emerging market equities underperformed developed markets by almost 30%. 1 However, underlying these factors are further drivers of return, which may be powered by the behavioural biases of investors or compensation for risk. 1 Throughout 2013, the MSCI World Index returned 27.4% versus the MSCI Emerging Markets Index return of -2.3% (in USD terms). 3

4 TO WHICH RETURN DRIVERS SHOULD INVESTORS SEEK EXPOSURE? The simple answer is that investors should seek exposure to those drivers of return that they believe will outperform (either in absolute or risk-adjusted terms) over the long term. So, which drivers are likely to outperform? This is, of course, a vexed question on which commentators, market practitioners, and academics will not always agree. At Mercer, we are wary of claims that certain return drivers are academically proven to outperform ( proven is a dangerous word to use in the investment industry, particularly in relation to the future). Nevertheless, there is evidence both empirical and economic rationale that can be used to assess whether a given return driver is likely to outperform in the future. We do not include the full detail of that evidence in this paper, but Table 1 lists the key drivers that Mercer believes should be reflected in investor s equity portfolios. Mercer has also undertaken an empirical analysis of these return drivers, building on the large body of academic work that already exists. Consistent with earlier work, we find that each of the drivers has a long record of strong performance, although the efficacy of each factor does vary. We also find that these drivers are, in general, good diversifiers to each other (that is, have typically exhibited low correlations), but that the characteristics of exposure to these factors has varied over time. We should note that this empirical analysis is limited by the amount of data available and is prone to data mining criticisms. The intuitive rationale for each driver is also subjective, so not all practitioners agree on the validity of each return driver. We recognise that not all clients are the same and that they too will have their own opinions on the validity of these return drivers. However, although there are other potential drivers of return, Mercer believes that investors should consider a positive bias toward the drivers of value, size, momentum, low volatility, and profitability. Mercer believes that investors should consider a positive bias towards the drivers of value, size, momentum, low volatility and profitability. Table 1: Key Drivers to Consider in Building an Equity Portfolio Driver What is it? Rationale Value Size Bias towards cheap stocks on a measure of value such as price to book or price to earnings Bias towards companies with a smaller market capitalisation Return enhancing due to (a) behavioural overextrapolation of earnings growth, (b) distress risk premium, and (c) the rebalancing effect Return enhancing due to (a) small company illiquidity and credit risk premia and (b) the rebalancing effect of selling stocks that have risen in price Momentum Low volatility Profitability Bias towards stocks that have recently performed well. Bias towards stocks with historically low absolute variability of returns Bias towards stocks with a strong measure of profitability, such as return on equity Return enhancing due to behavioural factors of (a) underreaction to company news, (b) overreaction to recent stock price performance, and (c) herding Risk-adjusted return enhancement due to (a) lottery effect whereby high-volatility stocks are systematically overpriced, (b) leverage aversion, and (c) tracking error constraints causing systematic overpricing of high-volatility stocks (as not owning these disproportionately increases tracking error) Return enhancing due to behavioural underestimation of the longterm sustainability of high-quality businesses 4

5 HOW SHOULD INVESTORS BUILD THESE RETURN DRIVERS INTO THEIR PORTFOLIO STRUCTURES? There are many different ways in which investors can structure portfolios to achieve exposure to these return drivers. No single way is best and different investors will have different objectives and practical constraints leading to different approaches. Hence, when deciding on an investment structure, investors should consider the following: What are the fundamental beliefs of the investor? Do these include a belief in the value of active management? What is the available governance budget (time, commitment, expertise, and resources) to build, monitor, and maintain an investment structure? Do the investor s goals and risk constraints impose limitations on the type of structure that can be adopted? In particular, over what time horizon does the investor set and measure investment goals? Does the investor have fee constraints (particularly if a DC fund)? Does the size of the fund impose any further constraints? This could be because either the fund is too small to adopt a complex structure or so large that finding product capacity is difficult. Having considered these issues and constraints, investors need to decide on a structure that works for them while achieving exposure to the desired return drivers. A spectrum of implementation approaches is shown in Table 2, and we use this to describe two possible approaches. Table 2: A Spectrum of Implementation Approaches Traditional index tracking Systematic strategies Active strategies 2 Market cap weighting Factor weighting ( indices ) Optimised ( strategies ) Benchmark relative Unconstrained Value Fundamentals weighted Value factor indices Fundamental value Core quant Size Equal weighted N/As Fundamental small cap Core quant Momentum N/A N/A Momentum factor indices Trend growth Core quant Unconstrained active Profitability Quality weighted Quality factor indices Quality growth Low volatility Risk weighted Minimum variance indices Minimum variance Defensive quality 2 The table is a summary schematic only, and does not show all the possible nuances. For example, some unconstrained active managers might have narrow exposures to certain return drivers. 5

6 We do not believe that these systematic products are a silver bullet. However, despite these challenges, Mercer believes there may be a role for systematic products. 1. Systematic Exposure to Return Drivers One approach is to use a combination of investment products that provide systematic exposure to the chosen drivers of return. These products (highlighted in blue in Table 2) are typically rules-based and are designed to specifically target one or more drivers. We can further subdivide these products into (a) factor-weighted indices and (b) optimised strategies. Factor-weighted indices are based on stock weightings other than market capitalisation. Examples include weighting by fundamental measures (for example, economic or accounting) of company size to target value or riskweighting to target low volatility. Optimised strategies are those that use quantitative mathematical algorithms to target the return drivers. An example is quantitative minimum variance indices, which target low-volatility exposure. Proponents of these approaches argue that the resultant factor exposures will achieve much, if not all, of the outperformance that can be achieved by traditional active managers. They further argue that these products typically have lower management fees. These systematic products and indices are sometimes referred to as smart beta products. We do not believe that these systematic products are a silver bullet. Although they can indeed provide investors with systematic exposure to specific return drivers at a relatively low fee (compared to typical active management fees), they do also present some challenges: The key drivers of outperformance may change in the future. A portfolio structure designed to gain exposure to the key drivers of the past may miss out on the key drivers of the future. A skillful active manager, on the other hand, may be more flexible in adapting to both tactical and structural changes in the market. When using traditional active managers, an investor delegates decisions on the return driver exposures (and the nature of their capture) to a fund manager. This is not the case when an investor decides upon a structure of systematic products. Although in both cases the investor retains a fiduciary duty, the function of factor selection is delegated in the former scenario but not necessarily in the latter. Investors should be aware when they have not delegated factor exposure decisions and make sure they have a clear understanding of the risks involved. In many cases, the evidence for the efficacy of these products is based on simulated returns and back-testing. Investors should remember that although life (and investment returns) can only be understood backwards, it must be lived forwards 3 returns might not turn out as hoped for. Not all systematic products are created equal; some are, in our opinion, better than others and demonstrate greater efficacy of factor exposure. However, despite these challenges, Mercer believes there may be a role for systematic products. For some years we have been advising clients to build equity portfolios with an explicit exposure to (among other things) low volatility, emerging markets, and size, and indeed some of our clients already use systematic products for the low-volatility element of their investment structures. 3 With apologies to the Danish philosopher Soren Kierkegaard ( ). 6

7 2. Active Management An alternative to using systematic products is to use one or more active managers in combination (highlighted in green in Table 1). Almost all active managers have a bias toward certain return drivers. We can think of each manager as having his or her own return driver footprint. An investor can build an aggregate portfolio with exposure to the desired return drivers by putting together a structure of managers with the right combination of footprints. We continue to believe in the value of active management. At Mercer, we continue to believe in the value of active management. Market inefficiencies will arise for a variety of reasons, from behavioural biases and investor constraints to an excessive focus on the short term. The nature and magnitude of these inefficiencies will vary significantly over time. Hence, we believe that skillful active managers can improve upon the risk/return characteristics of a market cap index or a systematic strategy designed to capture factor exposures. 4 We believe that a well-diversified equity portfolio that is biased toward value, size, momentum, low volatility, and profitability can be assembled with highquality, unconstrained active managers. Some investors might wish to use a combination of active strategies alongside systematic products. A number of our clients already use a combination, with active systematic products often used to provide low-volatility or value exposure. Systematic products can also be used in a completion role, whereby a tailored systematic product might be used to fill the gap between the aggregate footprint of an investor s selected managers and the investor s desired footprint. MERCER S RESEARCH OF SYSTEMATIC PRODUCTS Mercer maintains research on a number of systematic products that target return drivers. For those products offered as an index, Mercer assesses these using our Preferred Provider methodology. This approach is applied to strategies for which the primary goal is to track an index, and it is the same approach used for assessing conventional market cap weighted index products. We believe that skilful active managers can improve upon the risk / return characteristics of a market cap index or a systematic strategy designed to capture factor exposures. For those products managed on an active systematic process, Mercer assesses products using our traditional rating process. Strategies are rated using the Mercer rating scale or A, B+, B, or C, which is an assessment of the likelihood of whether a strategy will outperform a benchmark over a market cycle. 5 4 We do note, however, that our confidence in the value of active management can vary according to market and style. 5 For more details on this process, see Guide to Mercer s Investment Strategy Research Ratings, June

8 CONCLUSION Investors should think carefully about the underlying drivers of return when designing equity portfolios. In particular, investors should understand the different drivers of return and decide upon those to which they wish to have exposure. Although there are many potential drivers and not all commentators agree, we believe that investors should consider a positive bias toward value, size, momentum, low volatility, and profitability. There are many ways to implement an equity portfolio with targeted drivers of return. No single way is best, as different investors will have differing fundamental beliefs, goals, and constraints. One approach is to use a combination of systematic products that target drivers of return using a rules-based process. This approach has some merits, including typically lower management fees, but also presents some material challenges. An alternative is to use a combination of traditional active managers, being careful to ensure that (a) the aggregated return driver footprint of these managers is consistent with the investor s targeted exposures and (b) the chosen managers are skillful and likely to achieve performance in excess of a benchmark and the relevant systematic factor exposure. In the absence of any material fee or governance constraints, we believe that a diversified portfolio of active managers is a valid approach. We believe that skilled, active managers should be able to provide a more attractive risk/return trade-off on a net-of-fees (and costs) basis. However, the use of systematic products might provide a better fit with some investors beliefs, governance arrangements, or fee constraints. In particular, they can be used in a completion role or to target specific characteristics. Either way, our approach is straightforward. We incorporate factor analysis to ensure that when a client employs a manager, the client is getting what it expects and that it is paying appropriate fees for the expected alpha and not over-paying for simple factor capture. 8

9 For further information contact: CANADA DAVID ZANUTTO EUROPE MICHAEL KINNEY PHIL EDWARDS PACIFIC HENDRIE KOSTER hendrie.koster@mercer.com UNITED STATES ANTHONY BROWN anthony.brown@mercer.com IMPORTANT NOTICES References to Mercer shall be construed to include Mercer LLC and/or its associated companies Mercer LLC. All rights reserved. This contains confidential and proprietary information of Mercer and is intended for the exclusive use of the parties to whom it was provided by Mercer. Its content may not be modified, sold, or otherwise provided, in whole or in part, to any other person or entity, without Mercer s prior written permission. The findings, ratings, and/or opinions expressed herein are the intellectual property of Mercer and are subject to change without notice. They are not intended to convey any guarantees as to the future performance of the investment products, asset classes, or capital markets discussed. Past performance does not guarantee future results. Mercer s ratings do not constitute individualised investment advice. Information contained herein has been obtained from a range of third-party sources. While the information is believed to be reliable, Mercer has not sought to verify it independently. As such, Mercer makes no representations or warranties as to the accuracy of the information presented and takes no responsibility or liability (including for indirect, consequential or incidental damages), for any error, omission, or inaccuracy in the data supplied by any third party. This does not contain regulated investment advice in respect of actions you should take. No investment decision should be made based on this information without obtaining prior specific, professional advice relating to your own circumstances. This does not constitute an offer or a solicitation of an offer to buy or sell securities, commodities, and/or any other financial instruments or products, or constitute a solicitation on behalf of any of the investment managers, their affiliates, products, or strategies that Mercer may evaluate or recommend. For the most recent approved ratings of an investment strategy, and a fuller explanation of their meanings, contact your Mercer representative. For Mercer s conflict of interest disclosures, contact your Mercer representative or see Mercer s universes are intended to provide collective samples of strategies that best allow for robust peer group comparisons over a chosen timeframe. Mercer does not assert that the peer groups are wholly representative of and applicable to all strategies available to investors. Mercer Limited is authorised and regulated by the Financial Conduct Authority Registered in England No Registered Office: 1 Tower Place West, Tower Place, London EC3R 5BU