Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 205

Find a 'sweet spot' rather than complexity

There is a distinct trend in finance towards increasing complexity over time, including individual security structures, derivatives, the creation of new ‘asset classes’ or portfolio construction techniques that combine these in different ways.

With the pressure on headline fees and costs continuing to mount and as the desire to be seen as increasingly sophisticated or differentiated grows, there is a temptation to use more complex methods of portfolio construction in building multi-manager portfolios. It might be to incorporate ‘cheap’ factor tilts, barbell strategies of passive or semi-passive and high alpha concentrated portfolios or top 20 and ‘ex-20’ mandates. The ability to slice and dice a relatively fixed pool of assets into different constructs is ever present.

As a case study, in 2009 we undertook some analysis to determine whether the increasingly complex methods of constructing Australian equity multi-manager portfolios were, in aggregate after fees and costs, adding value. Our conclusions at that time were:

“Appointing fewer managers, to larger more diversified mandates with an after-tax focus, at a point on the cost curve where average fees are minimised, would result in better after-tax and fee returns at lower aggregate risk. Such structures are simple, require less governance and lower monitoring costs and will make it easier for internal investment teams to aggregate and monitor total portfolio risk.

Complexity is over-rated.”

Our 2009 study was based on all long-only large/broad cap active managers within the Mercer MPA Australian equity universe who had a three-year track record to either January 2000, January 2005 or January 2009. We specifically excluded long short, ethical/SRI or other overly thematic portfolios from the analysis universe (for example, income). Taking the 2009 data, there were 80 managers with a three-year track record. We note that of this 80, by February 2017, only 50 remain (in their current form).

Alpha versus risk in portfolios

While we observe that fees generally increase with the level of expected alpha (and complexity), investors should have a view as to how the reward for risk (sometimes called the ‘information ratio’) might change with increasing alpha. Given the asymmetry of payoffs between managers of assets and their clients, for these higher fees to be ‘worth it’, the information ratio needs to be increasing with the alpha expectation. This is particularly the case for strategies having fixed plus performance fee structures.

These payoffs are represented below (‘alpha’ is the excess return of a manager relative to a market index).

Source: Schroders, stylised charts for illustrative purposes only.

The general view in the industry appears to be that the first chart, and possibly the second, are what most investors expect. However, in our 2009 study we showed that, at least for Australian equity portfolios, the third chart is the reality. That is, as risk rises, there is a disproportionate fall in excess returns.

An update of the analysis and finding the sweet spot

We have now updated this work. The chart below shows, for the 96 long only managers with a three-year track record to February 2017, how their actual average alpha compares with their realised tracking error (ie variation from the index, used here as a measure of risk). While tracking error is not our preferred measure of risk (in fact it is counterintuitive), it remains common, certainly in single asset class portfolio construction. In addition, we have also included data points for the three years to January 2013.

Source: Schroders, Based on Mercer MPA data, all data is gross of fees.

Several observations are worth making:

  • The realised level of alpha in nearly all categories and time periods has been positive. Unsurprisingly, the high alpha category has been the most volatile in terms of delivery of excess return.
  • The ‘sweet spot’ for consistency remains strategies in the 2-5% realised tracking error range. These tend to be ‘core’ or ‘core plus’ strategies.
  • Very high tracking error strategies appear to have done well recently, as they did in the lead up to 2005.

However, we would hasten to add additional points in reviewing the data:

  • Survivorship bias (that is, the data is for managers who have ‘survived’ through the period, and perhaps the poor managers no longer exist) in the data is an issue. Several strategies in the 2009 data series have had their track records removed. In particular, for the high-alpha category, the survivorship bias is extreme with only eight of the 18 strategies from 2009 still ‘alive’ by February 2017.
  • Of the 80 (long only) strategies that had a three-year track record in 2009, only 50 remained by 2017, yet 46 new strategies have commenced in that time.
  • While this analysis looks at average levels of alpha, the most important thing for clients is real dollars of value add, not a percentage. For example, a strategy with $5 billion that has generated 1% of alpha (that is, $50 million) has performed significantly better than a strategy with $100 million of assets that has generated 10% of alpha (that is, $10 million). We note that almost all of the better performing strategies in the high-alpha category are very small in assets or closed to new business.

Constructing a portfolio

What happens when we construct different types of portfolios and allow for the costs of implementation?

In order to understand the likely post-fee impact of alternative strategy configurations, we need to make some broad assumptions about likely fee levels for different mandate types.

For the purpose of this analysis, we have made the following assumptions with respect to average fee levels. While one could ‘argue the numbers’, it is not so much the absolute levels that are important but the relativities between each type.

Source: Schroders assumptions. The ‘expected alpha’ amounts have been determined with reference to the averages from our four analysis periods. Enhanced core uses the averages from strategies with 0-2% tracking error, core is 2-4% and high alpha is >4%. We have not allowed for survivorship bias which could reduce the high-alpha numbers further. Many high-alpha strategies have performance fees which can materially skew fees higher in a multi-manager construct. For index managers, we assume a slight positive ‘alpha’.

Assuming a circa $5 billion Australian equity portfolio, the chart below shows the outcomes of different manager configuration options.

Source: Schroders. The 2, 4, 6 and 8 refer to the number of managers in the various multi-manager constructs.

There appears little benefit to more complex structures and the commensurate increase in fees and governance. By way of sensitivity, fees would have to be about 30% lower than that assumed for the high alpha category to be broadly equivalent to the core structures (assuming no cost to the increased governance and similar levels of survivability).

In 2009, former Chairman of the Federal Reserve, Paul Volker, commented on a conversation with a Nobel Prize-winning economist about the value of financial engineering to the real economy,

“Much to my surprise, he leaned over and whispered in my ear that it does nothing. I asked him what it did do and he said that it moves around the rents in the financial system and besides that it was a lot of intellectual fun.”

 

Greg Cooper is Chief Executive Officer at Schroders Australia. This article is general information that does not consider the circumstances of any individual.

 

banner

Most viewed in recent weeks

Retirement is a risky business for most people

While encouraging people to draw down on their accumulated wealth in retirement might be good public policy, several million retirees disagree because they are purposefully conserving that capital. It’s time for a different approach.

The perfect portfolio for the next decade

This examines the performance of key asset classes and sub-sectors in 2024 and over longer timeframes, and the lessons that can be drawn for constructing an investment portfolio for the next decade.

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

The challenges with building a dividend portfolio

Getting regular, growing income from stocks is tougher with the dividend yield on the ASX nearing 25-year lows. Here are some conventional and not-so-conventional ideas for investors wanting to build a dividend portfolio.

How much do you need to retire?

Australians are used to hearing dire warnings that they don't have enough saved for a comfortable retirement. Yet most people need to save a lot less than you might think — as long as they meet an important condition.

Welcome to Firstlinks Edition 594 with weekend update

It’s well documented that many retirees draw down the minimum amount required and die with much of their super balances untouched. This explores the reasons why and some potential solutions to address the issue.

  • 16 January 2025

Latest Updates

Investment strategies

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

9 ways to fix Australia's housing crisis

Decades of policy failure have induced a fall in housing affordability. Unless painful changes are made, an underclass will emerge in a society that is supposed to boast the one of the world's highest standards of living.

Shares

Australia: why the chase for even higher dividend yields?

Australia boasts one of the world's highest dividend yielding sharemarkets, providing substantial benefits to investors and retirees. Despite this, individuals often stretch for even more yield, to their detriment.

Shares

MIGA – Make Income Great Again

The Australian sharemarket seems to be rewarding a number of unprofitable companies on the promise of future riches. Yet profits and cashflows still matter, as a recent case study of Domino's Pizza shows.

Shares

Mapping future US market returns

Exceptional returns from the US sharemarket over the past decade have driven by sales growth, margin expansion, rising valuations, and dividends. Predicting future returns requires careful consideration of these factors.

Shares

Read this before you go all in on US equities

US equities rule global markets, but history is littered with examples of markets that seemed invincible — until they weren’t. Diversification will be key for investor portfolios going forwards.

Property

What impact would scrapping stamp duty have on housing?

Increasing house prices pose challenges for housing affordability. This investigates the impact of stamp duty on the property market, and how removing the tax could help address several key issues.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.