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Active Management: Feast and famine
NOVEMBER 2014 (MAGAZ
INE)
BY
MARTIN STEWARD
The ability to generate alpha might be a skill, but the amount of alpha available
from the market
is not a constant. Martin Steward asks how we might measure the
alpha opportunity and whether investors should vary the risk budget they allocate
to active management as a result
The debate about active and passive portfolio management is often carried on
as
though the potential returns to active management were static. But this is a little like
comparing the success of two agriculturalists without taking into account the fact
that one has been working with lush soil during a time of abundant rainfall whil
e the
other has been toiling in stony ground and a drought.
Like farmers, alpha generators will be more differentiated if they work in times of
abundant available alpha.
“In global equities, the median manager still outperforms, but to a lesser extent t
hat
before the financial crisis,” observes Lucy Macdonald, CIO of global
equities,
Allianz
Global Investors.
“The alpha is compressed.”
Unless we think that the asset management world has grown collectively dumber,
that must have something to do with the structure of the market
–
its ‘alpha
richness’.
Two observations suggest themselves as a result of this. First, investors shouldn’t
sim
ply give up on active management just because they see active managers as a
group struggling to generate significant excess return
–
this may be more to do with
the market environment than the ability of active managers. But second, it may pay
to vary the
amount of risk budget they devote to active management
–
investors
should make hay when the sun shines.
“If the cross
-
sectional volatility of the equity market is zero, meaning that all stocks
perform exactly the same, then all active portfolio returns e
qual the benchmark’s
return regardless of a manager’s active bets,” as David Schofield, president of Intech
International puts it. “To preserve richness of alpha in lower cross
-
sectional volatility
environments, it would seem advisable to increase the acti
ve share of a portfolio in a
risk
-
controlled way.”
Conversely, an investor may respond to an ‘alpha
-
poor’ environment by simply doing
more investment passively, to cut fees.
Ratio
But how should we measure ‘alpha richness’? Schofield refers to cross
-
sec
tional
volatility
–
or ‘dispersion’. This is the extent to which the volatility of individual
stocks in the market differs from one another; it is higher if the stocks are all
oscillating by similar amounts, and lower if they are oscillating by very differ
ent
amounts.
Others would point towards cross
-
sectional correlation
–
the extent to which
individual stocks tend to move in the same direction as one another.
“Following the financial crisis, high levels of correlation made it tough for active
managers
to add value,” as Liad Meidar, managing partner at consultant Gatemore
Capital Management, puts it. “Correlations coming down have created more room to
add alpha.”
At a glance
• Alpha richness in markets fluctuates through the future, but is the market al
pha
rich today?
• Correlation says yes, dispersion says no
–
but the diversification ratio suggests the
balance is in favour of alpha richness.
• Can we predict alpha richness and adjust risk budgets accordingly?
Intuition might suggest that the two mea
sures ought to agree, roughly, on the level of
‘alpha richness’. But for the past three years they have both moved steadily
downwards. While stocks in the market have been moving more and more
independently of one another, creating more opportunities to ta
ke bets with returns
different from the market’s, the amplitude of each stock’s movement has been
continually compressing.
“At the moment, we are seeing all
-
time lows in cross
-
sectional volatility across all
markets,” observes Sorca Kelly
-
Scholte, managing director in client strategy and
research at
Russell
Investments
. “That would suggest that it’s a poor time for active
managers to differentiate themselves.”
Craig Lazzara, senior director in index investment strategy at S&P Dow Jones
Indices, agrees, and says that this explains the “difficulty active manag
ers have been
experiencing recently”, despite falling correlation.
“Correlations might be low, but the correct metric for stock
-
selection opportunity is
dispersion, which is close to all
-
time record lows in almost every market we look at,”
he says.
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