In the current low return, low interest rate world in which we find ourselves, the vast majority of active managers look for outperformance through the application of fundamentally based stock selection. However, contrary to many investors’ perceptions that excess returns are derived purely from skilled stock picking, the bulk of the relative performance of these active managers actually comes from their exposure to various sources of excess return.
This includes premiums from varying investment strategies, among others, the small-cap, value and momentum.
To identify the relative performance of value, momentum and small-cap strategies, one needs to look at the MSCI SA Value Weighted Index and the MSCI SA Momentum Weighted Index against the MSCI SA Index from November 2001 to January 2015, as well as the FTSE/JSE Small Cap Index against the FTSE/JSE Weighted All Share (SWIX) Index.
In South Africa, these strategies generated meaningful excess returns over the medium term. However, it is interesting to note that the value-based strategy has not outperformed the MSCI SA Index over the past 14 years. After initially outperforming, this strategy has underperformed significantly over the past six years, a period characterised by strong equity returns on the back of loose monetary policy and quantitative easing.
The experience of value-based strategies in South Africa over this period provides insight into one of the key drawbacks associated with harvesting excess returns from a single risk premium, namely that returns can be cyclical. This cyclicality has two main implications:
- Investors aiming to extract outperformance need a long-term buy-and-hold investment approach and the risk tolerance to endure significant short- to medium-term underperformance.
- The timing of an investment aimed at capturing one or more of the above-mentioned sources of excess return can have a material impact on an investor’s long-term performance. This was well illustrated in the relative performance of both value-based and momentum strategies during the financial crisis when the charts were almost mirror images of each other.
So is the average general equity fund value biased? We analysed the performance of the general equity peer group average from December 2001 to February 2015 to provide a good indication of how the average portfolio manager in South Africa performs relative to the market. We discovered that the average returns generated by general equity unit trusts were better than that of the market 54 percent of the time.
This indicates that unit trust portfolio managers do, on average, add value to investors. However, it is evident that their good performance was biased under certain market conditions. When the MSCI Value Index outperformed the MSCI Momentum Index, the average return was better than that of the market 63 percent of the time. As suggested by its name, the Value Index has a value style bias. This indicates that the average portfolio manager is overweight high value shares.
The Value Index has been through long periods of underperformance, which suggests that if you wish to have a smoother return path, you need to diversify your portfolio in terms of style risk.
A possible explanation for the underperformance of value-based strategies, as well as for the cyclicality of returns, can be found in the Adaptive Market Hypothesis, as posited by Andrew Lo in 2004. This hypothesis implies that the degree of market inefficiency – and hence opportunity to generate excess returns – is related to the number of competitors in the market and the adaptability of market participants. These factors materially impact the waxing and waning of various strategies and, in turn, have a direct impact on the cyclicality of returns.
Prior to 2000, there were a limited number of value managers in South Africa. By implication, the opportunities open to value-based managers were large, given the small number of market participants exploiting this source of excess return. Post the TMT collapse in 2001, a number of investment houses reinvented themselves as value-based managers. “New era” funds were closed and investment houses that were historically momentum or growth managers restructured and became value managers. Given this shift, the number of investors seeking to exploit the value premium increased and, consequently, the opportunities to profitably exploit this value premium declined over time.
Conventional approaches to exploiting risk premia generally involve exploiting one source of excess return on a buy-and-hold basis. Although this approach should result in outperformance over the long term, short- and medium-term underperformance can also be significant. Many investors simply cannot tolerate these periods of underperformance. The net result is that investors switch strategies at the wrong time, resulting in long-term underperformance. This was highlighted in Morningstar research that compared fund returns with what investors actually received. At the end of 2013, the 10-year gap between the return the average investor received and what the average fund delivered, was 2.5 percent a year. Compounded over the 10-year period, this has a significant negative impact on an investor’s portfolio.
Given investor behaviour as outlined above, diversification across different sources of excess return becomes an attractive proposition. Not only should such an approach result in outperformance over time, but this outperformance should be much more consistent, and the overall portfolio less prone to periods of cyclical underperformance. In addition, the risk-reward relationships for risk premia are constantly changing as market conditions change. Diversification across a number of risk premia (value, momentum, size, risk etc.) combined with an allocation approach that successfully adapts to the changing market conditions, should give the best long-term return outcome.
Grant Watson and Saliegh Salaam, Joint Boutique Head of Customised Solutions, Old Mutual Investment Group