Maximising returns not risk

For some years now, market analysts have been warning investors that they should prepare for lower returns, with many arguing that the high return drivers of the 1980s and 1990s have largely run their course.

These drivers included such things, as attractive starting valuations, the move from high to low inflation, deregulation policies and the wealth accumulation phase of the baby boomer generation as well as the peace dividend from the end of the Cold War.

Faced with this changing environment, fund managers around the world have been queuing up to release ‘high conviction’ funds to generate returns that exceed market benchmarks (alpha).

High conviction funds offer investors the opportunity for higher returns compared to traditional, more diversified funds.

However, investing in a high conviction fund does bring with it additional complications and risks.

Most importantly, not all high conviction funds are successful. There is a wide dispersion of returns between the best-performed high conviction funds and the laggards.

This means manager selection and monitoring is critical. Sector and style biases are also important drivers of fund performance.

According to Russell’s models, a high conviction approach to equities investment delivered an average outperformance of 3.1 per cent over the S&P/ASX 300 benchmark for the three years ending July 2006. By comparison, more traditional approaches outperformed by just 1.2 per cent.

Russell’s findings are based on a recent study of 72 Australian equity funds, of which 18 were classified by Russell as high conviction based on the stock and sector composition of portfolios.

Funds classified as high conviction owned an average of 41 stocks compared with 81 for traditional managers. High conviction funds also took much larger stock and sector positions relative to the benchmark.

What is a high conviction fund?

The main difference between a traditional and high conviction fund is that high conviction funds tend to hold fewer stocks and take larger positions relative to the market benchmark. High conviction funds pay far less attention to the need for diversification.

The table above shows that the level of sector divergence (DI) for high conviction managers in Australia is over three times larger than the DI for traditional fund managers.

This means high conviction managers are taking substantially larger sector bets than their traditional counterparts.

As you might expect, the possibility of higher returns increases the potential risks, with the most obvious being greater tracking errors relative to the market.

In addition, choosing the right fund manager becomes even more critical. High conviction funds also tend to have much shorter performance histories and far less funds under management.

Is it possible to reduce the risks without impacting returns?

As part of our research, we took a detailed look at two actual high conviction Australian equity managers and the benefit a multi-manager approach can deliver to investors.

The first high conviction manager followed a growth investing style while the second adopted a value investing style.

The value manager had a stock level DI value of 3 per cent while the growth manager had a stock level DI of 2.8 per cent. With the sector level DI values at 7.6 per cent and 3.3 per cent respectively, both managers clearly had large sector bets that could potentially lead to significant underperformance.

By taking an equally weighted portfolio of these two managers, we were able to yield a sector level DI of 2.5 per cent, which represented a material reduction in the level of sector exposure, especially given the extreme sector positioning of the value manager.

Importantly, this reduction in sector bias was achieved without compromising each manager’s stock picking skills in their respective portfolios. As such, we were able to reduce the risk without lowering the expected alpha returns.

How much should investors commit to high conviction funds?

The amount that investors should be encouraged to commit to high conviction Australian equity funds depends very much on the investor’s tolerance for increasing tracking error.

The allocation of monies to a high conviction fund will normally come at the expense of existing investments in Australian equities, since the decision to employ a high conviction approach is normally based on a desire to obtain higher returns, not to change the strategic asset allocation.

As such, the willingness of investors to allocate all or part of their existing Australian equities exposure to high conviction managers will depend on their individual tolerance to risk.

That is why the adoption of a multi-manager approach is proving increasingly attractive to financial planners and their clients, because it does enable them to reduce the burden of higher tracking error without negatively impacting the potential for alpha.

In fact, a well constructed, high conviction multi-manager portfolio will often have lower tracking error than a single traditional manager, but with much higher alpha potential.

Multi-manager investing also provides a solid risk controlled alternative to what could be a very bumpy ride for investors exposed to individual conviction managers, because it moves the role of risk control from the individual manager to the multi-manager.

The overall benefit of this is that it allows the investment manager to focus on what it does best — picking stocks — and the multi-manager to concentrate on what it does best — evaluating fund managers and bundling them together to manage risks — while still retaining the investor’s potential for more aggressive returns from a high conviction approach.

Why invest in a high conviction fund?

On the face of it, the intuitive appeal of hiring a high conviction investment manager is simple. Portfolio managers with genuine skills are allowed to focus on their best stock ideas and use these skills to enhance returns with as few constraints as possible.

These portfolio managers are also allowed to focus on those areas of the market where they have the most information advantage, rather than having to manage risks and hold stocks in which they have little conviction.

However, when it comes to choosing the right high conviction manager and fund, great care needs to be taken.

There are a whole host of issues that planners and individual investors should take into account before taking the plunge.

Do high conviction funds deliver?

According to Russell’s research, on average high conviction managers have largely delivered on their promises by achieving higher returns and information ratios compared to their traditional counterparts (see graph 1 Money Management Magazine March 8, 2007 page 32).

For example, the average level of outperformance by high conviction fund managers between January 1999 and January 2006 was around 8.5 per cent.

Interestingly, this tended to be achieved in the first year of a high conviction fund’s inception. The level of outperformance declined to 5.9 per cent and 2.8 per cent respectively in years two and three. In addition, the difference between the best and worst high conviction managers during the same period was 21.5 per cent.

This says two things to us.

First, you have to be quick off the mark, which means you need good research.

The well documented ‘boutique effect’ clearly suggests that new funds management operations deliver strong performance early on as the manager attempts to create a performance track record. The lower levels of funds under management make this easier.

Second, manager selection is critical when it comes to choosing a high conviction fund.

While the average high conviction manager has done very well, investors in the poorer performing high conviction funds have done extremely poorly.

Investors also need to be aware of the influence that style bias can have on the performance of a high conviction manager.

An investor will gain little comfort from investing with a high conviction manager skilled at selecting stocks with value characteristics if the market is rewarding stocks with growth characteristics.

This effect also means that investors should be very wary of using past performance as a guide to these managers.

Strong style tailwinds that made a particular high conviction manager look remarkable in one period could easily turn around to be a formidable headwind in the next.

High conviction managers are very dependent on the stock-picking opportunities that are available in the market.

Our research has revealed that a rise in cross sectional market volatility from current low levels could be very positive for the more skilled players (see graph 2 Money Management Magazine March 8, 2007 page 32).

However, it might also further increase the issue of performance dispersion, as mistakes made by less skilled managers prove more costly.

While higher tracking errors are mostly guaranteed with a high conviction approach, higher returns are not. Higher returns will only materialise if the fund manager possesses the right skills.

Thus, quality manager research is essential if investors are to avoid the downside associated with misplaced conviction in a high conviction manager.

What is the best way to adopt a high conviction approach?

One of the best ways to capture the upside of a high conviction approach while reducing the possible downside of increased risks is to adopt a multi-manager approach.

This is because multi-managers have extensive experience in manager research that enables them to screen out low skill, high conviction managers and continuously monitor their manager line-up.

They also have the ability to carefully blend high conviction managers, each with different styles, habitats and investment approaches, to achieve an optimal combination.

One common misconception about using a multi-manager is that this defeats the purpose of high conviction investing.

In reality, by combining two or more managers with positive expected alphas you can actually reduce tracking error without negatively impacting the expected returns.

In addition, a multi-manager approach minimises the risk of choosing an unskilled high conviction manager, because multi-managers have such strong abilities in manager selection.

A high conviction manager whose style is temporarily out of favour will represent only around 20 per cent of a properly structured multi-manager high conviction portfolio rather than 100 per cent.

A multi-manager approach also allows financial planners and investors to choose which types of risk they wish to avoid and those they wish to exploit.

Portfolio construction matters, too.

The primary rationale for choosing a high conviction manager is that they have some skill in stock selection and, if allowed to focus attention on their highest conviction ideas, will generate higher returns compared to a more diversified approach.

Unfortunately, a high conviction approach to stock selection often results in unwanted factor and sector biases such as a small cap or growth bias or a significant underweight position to the resource sector.

If not addressed, these risks might outweigh the benefits of enhanced returns.

A carefully constructed multi-manager structure allows the stock selection skills of different high conviction managers to shine through without the potentially higher returns being swamped by large factors and sector tilts.

Such large sector bets can have a swamping impact on performance.

For example, one of the worst performing high conviction managers over the past year, which was underperforming by around 10 per cent, had the third highest sector level divergence index.

This underperformance was due to a 10 per cent underweight position to the materials sector combined with a similar overweight position to underperforming consumer discretionary stocks. These sector tilts dominated otherwise strong stock selection within market sectors.

Peter Gunning is the chief investment officer at Russell Investment Group , Asia Pacific.