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The quest for the ‘Holy Grail’ of investment

Genuine uncorrelated alpha is the holy grail of investments, writes Michael Block, but managers and strategies that can actually generate it are hard to find. So what’s a poor boy to do?

In a previous article I suggested that now is a great time to diversify away from long-only equities strategies and, in particular, to look for skill-based strategies. The reasons are pretty obvious, namely that equities are still expensive and there are some concerns about bonds being used as a diversifying asset in a rising interest-rate environment. A long time ago, in a galaxy far, far away an asset consultant suggested that a shopping list for diversifying away from equity risk was:

  • Credit;
  • Term risk (including illiquidity);
  • Alternative beta (including factors); and
  • Skill (Alpha)

Clearly the best of these is the uncorrelated return series coming from skill, namely genuine alpha. The reason that genuine alpha is the Holy Grail of investment is because adding it to any portfolio improves the metrics of that portfolio with the promise of increasing returns and/or reducing risk (given that I used to work for Australian Catholic Super I could not resist the religious reference).

Unfortunately, many strategies are really beta dressed up as alpha and whilst they increase returns against a sector benchmark their correlation to other strategies, in particular equities, limits their usefulness for inclusion as part of the whole portfolio.

Over the past 40 years I have dedicated my career to a forensic examination of luck versus skill. There are some strategies that clearly add value but because there is a correlation between them and equities I do not see them as genuine uncorrelated alpha (e.g., adding certain higher-risk credit instruments to a portfolio).

There are some strategies where only a small percentage of managers add value at all, let alone with skill. That is not to say that there are not many great global equities managers – just that it is harder to find them. I have two over-arching guiding principles that help me decide what is and what is not alpha and where to look for it.

  • it makes the most sense to look for alpha in areas that are less well researched
  • any return stream that is structural in nature or that can be replicated by an algorithm (e.g., beta prime) is not worth having in the portfolio and is not worthy of active management fees.

The strategy that as a whole demonstrates the most persistent source of uncorrelated added value is private equity (PE). Even after allowing for gearing, the fact that returns/IRRs are most often expressed relative to drawn capital rather than committed capital, and adjusting for the lower average capitalisation of the companies, there is still persistent uncorrelated alpha.

The great George Roberts of KKR always said that “if one was prepared to give up the liquidity of public markets then private equity provides a great source of added return and was the best long-term investment available”. Contrast this to my view as to the strategies that as a whole demonstrate the least persistent sources of uncorrelated added value, namely global large-cap developed market equities (in particular the United States) and global listed infrastructure.

Once again, I am not saying that there are not great managers in both of these sectors, but just that it is harder to find those great managers and ceteris paribus unskilled investors should consider passive investments in these sectors.

Well, now what can a poor boy do? (Apologies to Stones fans). My suggestions about where to be active and passive largely coincide with research conducted by Mercer almost 20 years ago. The research looked at where alpha was best able to be sourced for a fair fee, essentially a shopping list of where an investor might best spend his/her fee budget. Of course, the corollary was a listing of those places where alpha was harder and/or more expensive to find. Unsurprisingly, that research reached very similar conclusions to mine.

So, be more active in sectors where you get the best “bang for your buck” and you stand a reasonable chance of adding value – namely PE, Australian equities, emerging market equities and some private markets. Be less active (whether passive or using alternative beta such as style factors) in areas where it is harder to find the good managers like global developed market large-cap equities and global listed infrastructure, unless of course you have the skill to find the good managers. But what about fixed interest you say? I will leave that for another day.

Here are some additional traps to avoid.

Do not confuse added returns from lower grade credit with alpha (e.g. compare sub-investment grade credit such as hybrids, HY and private credit to cash plus an appropriate margin). Do not confuse structural beliefs such as style biases for alpha (e.g. compare a growth equities strategy with a growth-style index rather than a broad equity index). Do not confuse lack of regular valuations with low price-volatility and low risk, particularly in unlisted real asset strategies.

Be careful when paying a performance fee over a fixed preferred return (I prefer a variable benchmark such as a margin over MSCI ACWI). There is no value added if the market goes up 15 per cent and a strategy makes 15 per cent. Conversely, there is great added value if the markets go down 10 per cent and a manager only loses four per cent. Obviously there are challenges in getting stakeholders to agree to a performance based fee where a manager gets well paid for a negative return.

Look at ungeared returns as well as overall returns so as not to confuse financial engineering for alpha. The great advantage of being less active in large-cap global equities (if one chooses to do so) is that the fee reduction gives rise to additional fee budget for those strategies which are more expensive and more rewarding such as PE and other alternative strategies.

Another unintended side benefit of holding passive equity strategies is that it reduces discussion about individual managers in favour of asset allocation considerations. Given that I believe that asset allocation accounts for at least three quarters of return outcomes, having more robust asset allocation discussions appears worthwhile, especially in a YFYS world that encourages more asset allocation tilts and renders active management strategies riskier from a regulatory perspective.

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