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Alpha, Schmalpha and the Persistence of Sub-Optimal Business Models and Investment Advisory Offerings

Posted by: Tom McKeon on March 19, 2018

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Low-Cost ETFs continue to expose discredited investment strategies and legacy business models.

or

Your investment outcome is largely a function of your advisors' business and service model, not his investing acumen.

Alpha is a much used word around the investment industry. It is an investment performance statistic measuring a portfolio manager’s ability to outperform a benchmark, on a risk-adjusted basis. It is different from Excess Return—see the definitions below from INFORMA Zephyr Style Advisor—a leading investment performance analysis firm, although the terms are often conflated.

 
Alpha
Alpha measures the risk-adjusted added value an active manager adds above and beyond the passive benchmark. Positive = good, negative = bad. It is entirely possible that a manager could outperform the benchmark and have negative alpha. Conversely, it is entirely possible for a manager to underperform the benchmark and have a positive alpha, if the risk statistic was sufficiently low.

Excess Return
The simplest of the benchmark-relative statistics, excess return measures the difference between the manager return and the benchmark return. Excess return is frequently confused with alpha. The two are not the same. Alpha first adjusts for market-level risk before calculating manager skill. Excess return does not.


Full disclosure: for many years as an investment advisor and portfolio manager at a previous firm I too was an active stock picker, operating on the premise that I could outperform—absolute and risk-adjusted—a passive benchmark net of costs. Sometimes I did, sometimes I did not.

I no longer labor under that illusion—that I could consistently outperform the “market” net of fees. And my clients no longer suffer from the direct cost and performance volatility that delusion.

The investment industry grew up and matured around the notion that smart managers and analysts could identify, research and build portfolios that would outperform a passive benchmark like the S&P 500. To this day, money flows into mutual funds that get a Morningstar 4 or 5 star rating, as legions of investors have been trained to believe that it is possible to outperform and that paying the excess fees are justified.

If only they would look at the data.

 

Can’t Escape Mean Reversion
Investing in a mutual fund after it has earned a 4 or 5 star rating from Morningstar—after it has outperformed—is a sub-optimal pursuit. That is simply because active manager performance varies around the benchmark and periods of outperformance are typically followed by periods of underperformance. Reverting to the mean is an inescapable reality for the vast majority of portfolio managers. There will of course be some performance outliers…but trying to identify them beforehand is effectively impossible.


The Very Good News
Truth is, not only is it possible to have a good investment outcome without pursuing or capturing alpha, it is far more likely. A purely passive approach to investing—no alpha seeking—offers investors the best chance to capture market returns, minimize costs, and achieve their objectives. Remember Jack Bogle’s irrefutable maxim: “in investing, you get what you don’t pay for.”

A paper published in the Journal Of Portfolio Management in 2012,  (The Norway Model: by Chambers, Dimson and Ilmanen) explored the fact that the Norwegian Government Pension Fund Global (GPFG) was ranked the largest investor in the world and at the time, second largest sovereign wealth fund, behind Abu Dhabi. Its size is not the focus of the paper however. The focus of the paper is that the largest investor in the world invests exclusively in publicly traded securities on a purely passive basis. They simply seek to capture global market exposures as efficiently as possible, and minimize costs.

Originally the fund was only allowed to own bonds. Its allocation now includes equities, emerging markets, corporate bonds and mortgage backed securities, inflation-linked bonds, small cap equities and real estate. It is a fully global and optimal allocation.

From the paper:
 
There is only one consistent source of performance deviations
from the benchmark; it is not stock and sector selection
skill, but cost drag. Investors would do well to control all
elements of fee and cost inefficiency in their portfolios.


When the largest pools of assets in the world abandon the futile pursuit and high costs of trying to outperform passive benchmarks, it is a strong indication of what the future of investing should and will look like.


Enter Indexing and ETFs

From iShares—the largest sponsor of Exchange Traded Funds.

Index funds are simple, low-cost ways to gain exposure to markets. They’re most commonly available as mutual funds and exchange traded funds (ETFs). While stocks, bonds, commodities and real estate have been around for centuries, index funds have revolutionized how investors access these assets.

It really is that simple. Ultra-low cost global market exposures are now available to investment professionals, institutional and individual investors alike—large or small.

Advisors, institutions and investors who are open to evidence-based investing, better diversification, global allocations, full transparency and low costs are voting with their dollars and increasingly turning to passive market exposures in the form of index mutual funds and ETFs. Asset flows for several years have overwhelmingly gone to passive products, largely ETFs. This sea-change in investor behaviors is causing great distress in active-management land, to the point where many of them are pushing back with promotional material and messages that relies on fully debunked claims or less than honest assertions. The shift to ETFs is well underway and like water flowing downhill, assets are never going back to active management land.

Human nature being what it is, it’s not surprising how many investment professionals cling to their legacy business models and advice package services.

 

Tales From the CIO Roundtable
Once a quarter, I am invited to meet with the Chief Investment Officers of a number of local advisory firms. Usually about 8 to 10 guys (yes all guys) turn up at the meeting. It is a chance to network and talk shop with fellow professionals. Often a guest speaker is invited, almost always a wholesaler from a fund company.

They are all good guys—smart, engaged in their business, entrepreneurs—and all of them have bigger businesses than Clothier Springs. And since anyone can view their fee schedules from the SEC’s website, I know how much they charge. All of them charge more than Clothier Springs…some more than double what we charge for investment advice, wealth or portfolio management.

What’s more, the range of investment advice offerings from the various firms represented is quite large. Only one or two of the firms represented are an institutionally focused manager. The rest are all wealth managers: meaning they primarily serve private clients and tend to manage most or all of the client’s investable assets.

Here is the portfolio management/service offering you will get from some of the firms in the room:

Firm A: a portfolio of US Large Cap Stocks and a few bonds.

Firm B: a go-anywhere portfolio of large, mid or small US Stocks.

Firm C: an advisor who builds allocations of actively managed funds and believes he can add value by selecting funds that outperform. See Morningstar above.

Firm D: An advisor building allocations of low-cost, no-load index funds. Outside of CSCM this is the most robust service model at the meeting.
Firm E: an advisor building portfolios of no-load funds and some ETFs

Firm CSCM: an advisor building broadly diversified, globally allocated, ultra-efficient, low cost, liquid, transparent and hedged portfolios for a very low fee. We also now have a partnership for private market investments.

Arguably, compared to the other firms represented at the meeting, investors who engage CSCM will get portfolios that are more efficient: better allocated, more broadly diversified, partially hedged, and risk-reduced.

 

The Litany of Invalid Premise’s
The premise that it is possible to beat the market regularly after fees: invalid.

The premise that an investor only needs exposure to US stocks and bonds: invalid.

The premise that a manager who has the latitude to “go-anywhere” can regularly beat the market after fees: invalid.

The premise that an advisor can routinely identity a mutual fund manager who will outperform in the future: invalid.

Arguably, almost everyone in the quarterly CIO meeting plies a demonstrably sub-optimal advice offering. As I sit at these quarterly meetings, I wonder how some of them get away with it. All of the guys are competent and ethical. But the biggest determinant of their client’s outcomes is their business model and advice package.

What they do for their clients is more a function of what they have always done or what they are comfortable doing: not what is in the best interest of the client.

And all of them charge roughly twice what CSCM charges. I wish them well and look forward to the day Clothier Springs can compete for their business.

There was a time the I too would have provided a wealth client with a portfolio of US Large Cap stocks with a few bonds. That time was more than 20 years ago. Global market exposures can now be had for next to nothing. Investment theory, best practices and products available to invest in have evolved.  Many advisors have not. They are at a competitive disadvantage, although the inertia of client assets and the lack of comparative information is the friend of the legacy advisor. Time and information is his enemy.


Structure IS the Answer!
Rejecting alpha seeking does not mean that portfolios should be static, set on autopilot. Markets and security prices are dynamic and in constant flux. Asset allocations should be periodically rebalanced to policy weights. This takes advantage of the disparity of asset prices and sells relatively overpriced assets and reinvests in relatively underpriced assets. Portfolio structure and periodic, if infrequent, rebalancing to asset class target weights are how returns are optimized, risk is mitigated and returns are captured.


It is easy to understand why some managers still promote alpha: it is the only way to justify higher asset management fees in the pursuit of better revenues, profits and bonuses for the manager. But with excess returns and alpha difficult to deliver to investors reliably and in resolving the permanent tension between manager profits and investor net returns, the scales have irreversibly tilted in the clients’ favor. We embrace that development. 

When you hear some portfolio  wealth manager speaking about his alpha, be aware that what he is really speaking about is his effort to justify a higher fee.

We go where the evidence leads us; to global allocations, to broader diversification, to rules-based hedging, to low-cost index-based investing. Clothier Springs remains committed to building strategies and portfolios that remain at the forefront of portfolio theory and best practices. Our clients reap the rewards: Better Outcomes, Less Risk, Lower Costs.


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