Alman Partners’ strategies are engineered to capture specific risk/return characteristics with reliability and transparency. The goal is to provide investors with a series of precisely defined, low-cost building blocks, allowing them to maximise the benefits of asset-class diversification when assembling balanced portfolios.
A study appearing in the journal of the Securities Institute of Australia (Drew & Noland, 2000) provides evidence that Australian investment managers are unable to add value consistently above passive strategies. These findings are consistent with previous studies conducted in Australia, the US, UK and Japan. The research findings in all these countries send a clear message: active management has lower returns than would be expected from passive management. Upon hearing about the research findings, investors sometimes respond that they are not concerned about the results of the average manager. They plan on hiring only the above-average managers. Further research in the US has addressed that issue and once again, the conclusions are negative. Managers with good track records are no more likely to have good records in the future than are managers with poor returns.
What Seems To Matter
Differences in average portfolio returns can be explained by differences in average risk. Portfolio management becomes an issue of asset allocation across the dimensions of risk rather than an issue of perceived money manager merit. The general accepted view of leading academics is that risk can be thought of as having the following dimensions:
- Fixed Interest
The two dimensions of fixed interest risk appear to be maturity and quality. Low quality obligations have higher returns than high quality obligations. To some, the difference is so great that they invest in high-yield strategies. The maturity dimension is somewhat more complicated. Longer-term obligations do not have reliable higher average returns than shorter-term obligations, even though their prices fluctuate more. Generally, investors concerned about return volatility should shrink away from long-term obligations.
The two dimensions explaining differences in average equity returns appear to be related to company size and financial health.
Small companies are those companies with small market capitalisations (price times shares outstanding). Value companies sell for low prices relative to fundamental measures such as earnings or book value, and are biased towards financially unhealthy companies. Growth companies represent high priced, financially healthy companies. In essence, risk is related to distress in an intuitively appealing way. Financially distressed value companies have higher costs of capital than financially healthy growth companies. When they borrow from a bank, value companies pay higher interest rates. When they issue shares, they receive lower prices.
A firm’s cost of capital is an investors expected return. If a company sells off 20% of its share, the investor gets a claim of 20% of the earnings forever. The return received by the investor is a return foregone by the company. It is hard to believe a share market could behave any differently. What would the world be like if the largest, safest companies offered the highest average returns?
These two dimensions of equity returns appear in all share markets around the world.
The Flaw of Active Management
The positive relation between distress and returns drives a spike through the heart of active management. Not many active managers invest in companies with poor earnings prospects and poor management. These are the companies with high costs of capital and higher expected returns. Much of the shortfall from active management could be due to their selling companies whose cost of capital have increased recently and buying companies whose costs of capital have declined recently.
Similarly, the relationship between company health and returns causes problems for fund trustees. Expected equity returns tend to be highest when economic prospects look bleak, and lowest when economic prospects look bright. Trustees often move in the opposite direction. When economic prospects worsen, share prices drop and trustees want to reduce their equity commitments. They wish to increase equity commitments when economic prospects look bright. The market has already discounted those prospects, so the timing of the equity commitment lowers average returns.
Asset Allocation: The Essence of Portfolio Management
Academic research points to asset allocation as the main emphasis of portfolio management. Expected portfolio returns are shaped by how much is invested in shares versus fixed interest. The fixed interest expected return is largely a function of the maturity and quality decisions. The share portfolio expected return depends on the proportions invested in international versus domestic shares, in value versus growth shares, and in small capital versus large cap shares.
Once an asset mix is established, investing is less stressful. There is no second-guessing of the manager because a passive fund always provides the return of an asset class within tight tolerances. There is no anxiety about market forecasting because the proportion of the portfolio invested in each fund remains fixed.
In summary, logic and empirical evidence overwhelmingly favour an investment approach based on asset class funds. The returns are higher and the fees are lower. The returns of an asset class are assured. Discipline keeps the portfolio fully invested, thereby avoiding the adverse timing pitfall inherent in investment committees and active managers.