Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Active adds value, but costs more controllable: CEM
According to institutional investor research house CEM Benchmarking the approximately 500 mega funds in its global database have delivered an annual net value add (NVA) of 0.16 per cent on average during the last 30 years. But the slim yearly margins add up over time to almost US$200 billion, CEM chief Rashay Jethalal (pictured) says in the group’s latest quarterly newsletter.
“For context, only 6 retirement funds in the U.S. today have more than US$200B in AUM,” Jethalal says.
In gross terms (netted for transaction costs), the CEM-tracked institutional investors returned an average 0.69 per cent above-benchmark each year over the previous three decades.
“With 80 per cent of AUM actively managed, investment teams have been able to beat their benchmarks, before cost,” he says. “As a reminder, we measure performance relative to benchmarks at the total fund, asset class, and mandate levels.”
Investment expenses sliced 0.53 per cent on average off the gross returns, leaving 16 basis points on the table for institutional fund clients. But while the CEM data provides some support for active strategies, Jethalal says cost management remains critical in keeping funds above water over the long term.
“As time horizons get longer, gross return performance increasingly follows a random walk, whereas the performance of costs is persistent,” he says. “This means that costs are, ultimately, more controllable. Managing costs matters.”
However, the CEM data shows that fund costs at either extreme were not correlated with maximum net value-add. If the long-term results are reassuring, institutional investors do have to ride out considerable year-to-year volatility in active management results, Chris Flynn, CEM custom research manager, says in the newsletter.
“While the long-term average doesn’t move much year to year, the average NVA each year can be significantly lower or higher,” Flynn says. “There are ‘better’ and ‘worse’ years for active management in the database, both at a total fund level, and within asset classes.”
Last year, for instance, active US equities strategies generally paid off for the defined contribution funds in the CEM universe that have reported to date while the cohort lagged the index in offshore shares.
“Worth noting: 2020 was a very different year, as non-U.S. stock and U.S. Large Cap were the winners in adding value over benchmarks,” Flynn says. “Global stock managers in 2020 had an average NVA of close to 80 bps, a gain that more than offsets the negative NVA in 2021 and 2022. By contrast, 2020 was a neutral year for U.S. Small and Mid-Cap.”
