Factors and Fund Managers
In the last video I went over the science behind investing. Explaining that there are certain 'factors' which have been proven to generate market-beating returns over time. How exactly do star managers fit into this framework? Well this is where 'factor regressions' come into to play.
A reminder - what are factors?
They are proven characteristics of certain stocks which provide higher returns over long time horizons. Have a look at the infographic below for some of the criteria to be seen as a valid factor:
What is a 'factor regression'
It's basically a bit of analysis where you look at the performance and see what part is attributed to known risk factors. The questions is simply - can you look back at successful fund managers and work out whether their performance was due to factor allocations or whether it was skill and timing in picking the right stocks? If we know what causes fund manager outperformance then simply we decide whether we truly want the manager or just the style. This is especially important as many factor funds may be considerably cheaper and with less concentration than some of their active counterparts.
It is important to note that 'after-the-fact' analysis doesn't detract from the real performance here. It is one thing to apply a strategy, another thing to successfully stick to it successfully in real time. What we're doing here which is review with the clear benefit of hindsight. This analysis is from AQR who are a well respected global investment company with over 140 billion under management. Headed by Cliff Asness who was a student of Nobel Prize Winner Eugene Fama.
I have to caveat there made some names here because there is no way to evaluate imaginary fund managers. As always, this is by no way and endorsement or recommendation for any of these individuals. It's simply as real life examples by definition, need to have existed.
What is 'regression alpha'
This is the performance which was not able to explained via the factors. Effectively the value that the fund manager has added which does not have explanatory power by adjusting for the factors.
Neil Woodford
I know... big deep breath! What I'm referring to here is when Neil Woodford did in fact perform very well as a fund manager for Invesco. Over the period, Invesco’s High Income fund exhibits higher returns than the U.K. stock market (excess of cash returns of 6.7% versus 3.6%), with slightly lower volatility. So sounds pretty good right!?
It should be noted that any of these figures are gross of fees and trading costs therefore the alpha regressions which is the value added by the fund manager once adjusted for factors are not going to be underestimated. In fact, they are likely to be lower once adjusted for fees.
So what were the reasons for this? AQR found that when controlling for the value, quality and low-risk the majority of the explanatory power of the outperformance reduced.
Terry Smith
Probably seen as the most successful fund manager of recent time. What Terry Smith does very well is removes one of the biggest issues with many active managers which is - trading costs. In fact the Fundsmith's mantra is:
Only invest in good companies
Don't overpay
Do nothing
It is the 'do nothing' element which is deeply powerful as the reality is most active managers over traded significantly. An analogy about how damaging this is up against a generally efficient market is - it is the financial equivalent of running an Olympic 100m and every time you trade and get it wrong, your runner moves back 5 yards. The starting field (which is the market) is that competitive.
So Terry Smith has performed very well over the selected period. It has however been no secret that quality and profitability have performed particularly well for the past decade. Although the regression alpha remains higher than Woodford.
What can this tell us?
The reason why this is interesting is if you can understand the 'secret sauce' that creates the investment return. Then factors are the ingredients behind the strong returns you may see then you can use this to make an informed choice about what approach may be right for you. The same type of analysis was conducted on Warren Buffet in the paper 'Buffet's Alpha' which again concluded that the a large amount of excellent returns Buffet had experienced had also been down to correct allocation to known risk factors.
The sooner we remove the ‘smoke and mirrors’ behind the fund industry the better. This article is not to imply that no-one ever should use a fund manager. It just means that the explanatory power behind returns should be analysed on the basis of whether they are down to luck or an allocation to an already identified risk factors. Then a judgement made on whether it is truly the fund manager who you want to go with, or a diversified approach towards a risk factor. As remember - a fund manager's past outperformance has no bearing on their future returns. Any deviation from an allocation to the general market can be well rewarded in the right environment or severely punished in the wrong.
To re-frame this it is always worth 'looking under the hood' at fund manager performance and asking:
Was their performance due to superior stock picking?
Or, have they been allocated to known risk factors?
Do we have good reason to believe this trend would continue?
The best tip I can give you is to acknowledge that any investment strategy should be for decades, not months and years. Therefore if you are behind a fund manager or factor style in order to take advantage of the tried and tested risk premiums you need to stick with it over a long timeframe. Otherwise it is just another version of market timing. We as humans are always going to be attracted to the 'cult of personality' which can often come with superior investment performance however as we saw with Neil Woodford this allure is tempting to follow until, normally all at once - it isn't.
Investment involves risks. The investment return and principal value of an investment may fluctuate so that an investor's portfolio, when redeemed, may be worth more or less than their original value. Past performance is no guarantee of future results. The information provided in this presentation has been compiled from sources believed to be reliable and current, but accuracy should be placed in the context of the underlying assumptions. Views stated here are individual.
All content is being provided for informational purposes only and should not be considered to be investment or tax advice. No investment decisions should be made solely based on the information in any of these videos or blog posts.
DATA -
https://www.aqr.com/Insights/Research/White-Papers/More-Superstar-Investors-Neil-Woodford-and-Terry-Smith
