If you are an investor with a return-seeking portfolio, chances are you will have significant exposure to equity markets.
Allocating to a variety of funds and having a long time-horizon is the basic default position of many institutional investors. That’s not a bad start. Can they do equities better though, especially in an environment where lower equity returns are likely going forward?
We think some institutions can leverage their scale and governance to manage more elaborate portfolios and achieve outcomes that more closely match their needs. Simple can be good, but simple can mean tracking the index — either intentionally, or inadvertently by getting index-like returns from active managers. We believe institutions potentially have many more options at their disposal.
Just like cooking up a great meal, each of these options must complement and enhance the others.
A great meal demands high-quality ingredients and, similarly, better equities start by sourcing high-quality, skilled investors.
It is our strong belief that active management adds value – passive investing has its merits, but cannot take advantage of market inefficiencies and therefore doesn't offer additional returns. At the same time, we fully acknowledge that finding skillful active managers is difficult. According to a report published by Standard & Poor's1, fewer than 20% of fund products outperform their respective benchmarks over five and 10-year periods after fees. For this reason, we devote significant resources to researching managers.
Some asset owners emphasize past performance in their manager selection. We are skeptical of track record alone as an indicator of skill, given that studies show a high degree of randomness in short to medium term investment returns.
We believe a better selection process combines quantitative analysis with a rigorous evidence-based qualitative assessment of investment skill.
Restaurant menus could be simplistically analyzed using the Pareto principle whereby 80% of profits come from just 20% of the menu items. So on larger menus, many items are just fillers. Likewise, we feel many traditional equity fund managers put “fillers” in their portfolios – lower conviction positions which may reduce the potential for excessive underperformance against the benchmark. Fund managers do this to help increase the scalability of their products and to protect their businesses from severe drawdowns. We feel the consequence to investors is that it may dilute returns after fees.
Research suggests that concentrated funds with higher “active share” tend to deliver superior returns after fees (Figure 1). Active share is the percentage of the portfolio different from the benchmark portfolio. A high active share portfolio, with perhaps 20 or so shares only, has a wider range of performance compared to the benchmark but, more importantly, has greater odds of success in the hands of skilled managers.
Source: Sebastian & Attaluri (2014), Petajisto (2013)
For this reason, we believe asset owners should encourage fund managers to use their skills to express only their best ideas through their portfolios.
Just as the perfect meal brings together a wide and complementary range of ingredients, so asset owners should aim to diversify to succeed in varying market environments.
We believe relying on a single manager creates dependency and execution risk. Combining multiple managers with different skills and approaches can help diversify the risks taken. If each manager has a focused mandate (10-20 stocks), the total portfolio would consist of purely high-conviction ideas, which we believe lead to a better risk-return profile.
Based on Willis Towers Watson Monte Carlo simulations on portfolios of randomly selected Willis Towers Watson’s top-rated, unconstrained active products. Likelihood represents 5-year probability of skillful managers outperforming the benchmark. Data source: Willis Towers Watson and eVestment
Food establishments that do not respond swiftly to customer feedback are at risk of obsolescence. Likewise, asset owners must respond to changing circumstances – shifts in the market environment or research views on managers – in a timely fashion to increase opportunities and mitigate losses.
Institutional portfolios tend to be managed in "calendar-time", rather than real-time, leading to delayed investment decisions and slow execution. We believe dynamic portfolio management can generate substantial value add over time.
How can asset owners keep a lid on costs while employing high-caliber fund managers and monitoring their portfolios dynamically?
Some institutional investors are sufficiently substantial to leverage their size and resources to reduce costs. We believe others can benefit from pooling arrangements. At Willis Towers Watson, we encourage the pooling of assets when sensible, and we leverage our long-term relationships with managers in exchange for substantial discounts on management fees. Active management does not come cheap but, by using scale and experience, fees can potentially be minimized. By committing to managers with long-term investment horizons and low portfolio turnover, transaction costs can be kept low, too. Furthermore, given our focus on skill and innovation, our manager research process allows us to be early backers of skilled managers, enabling us to negotiate better terms on behalf of clients.
Additional potential savings can be made through better scale and management of other operating costs, such as custody and administration. The use of tax-efficient investment vehicles can also translate into savings.
By employing high active share equity managers, best-practice portfolio management and cost-effective implementation, investors may improve their chances of better outcomes.
The worlds of equity investing and gastronomy may seem like chalk and cheese, but success in each follows a similar recipe.
In the competitive world of active management, asset owners hungry for success need to go further than simply selecting managers. The extra ingredients may seem burdensome for the average asset owner, but including them can help enable investors to improve outcomes.
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