1) MANAGER SELECTION
THE SEARCH FOR ALPHA
2) PAGE 1
The careful pairing of skilled managers within an asset class is one of two
requirements to achieve excess returns. The other is patience.
There is a powerful argument for passive investment strategies. Perhaps the most obvious is that
the average return achieved by all market participants is by definition the return of the market (less fees, of course). It’s a zero sum game,
with winners balanced by losers. To the degree
that an investor believes manager returns reflect
a “random walk down Wall Street” and/or that
they don’t have the ability to identify and utilize
managers who can really outperform over time, a
passive strategy is a way to simply “win by not
losing”.
Going passive is easy.
While there are some
nuances to passive management (such as which
index to use, market cap vs. fundamentally
weighted indices, etc), there’s little to do beyond
buying a group of ETF’s or index funds in a manner that tracks the desired asset allocation.
Assuming the investor prudently rebalances over
time, they will assure themselves of portfolio
performance that tracks the weighted indices
(less some amount due to fees and tracking error
of the investments versus the actual indices).
The investor will almost certainly never
outperform the markets, but neither should he
underperform by any significant amount.
But let’s say an investor both believes in active
management AND has the ability to do the due
diligence needed to identify managers who can
beat their indices over time. To outperform, a
manager has to make substantially different
“bets” than the index such as a concentration
of holdings, industry, or risk factors. While
these bets may lead to a higher average return
than the index (referred to as “alpha”), they
almost inevitably also lead to a higher volatility
of the manager’s returns than the volatility of the
index.
Volatility of returns is highly undesirable as it
can erode the manager’s excess returns due to
a phenomenon called volatility drag. As a simple illustration, a manager who returns +20% one
year followed by -10% the next has an average 5%
annual return but an IRR of only 3.9%. The
manager’s volatility has erased 1.1% of his
performance.
If increased volatility is a necessary outcome of
selecting a manager who can create excess return
over time, how does an investor prevent volatility drag from eliminating the outperformance
that he has worked so hard to find? The answer
is to simultaneously employ several complementary managers within an asset class, with each
manager having a distinctly different style and
expected source of alpha. Such a combination
can allow the higher levels of volatility of each
manager to offset each other and allow the excess return to come thru at the overall asset class
level.
There are two difficulties with such an approach.
The first is that it’s hard enough to find ONE good
3) PAGE 2
manager in an asset class let alone several that
complement each other, so an investor either
needs to spend a great deal of time and effort
doing so or outsource this to a capable
consultant.
The second problem is that the investor has to
accept that the volatility associated with each of
the managers he or she is using in such a strategy
means that there will certainly be periods where
each individual manager looks like a hero or a
goat as their style (and source of alpha) comes in
and out of favor. The investor must resist the
temptation to fire the “underperformer” or
load up the “outperformer” as long as the
overall mix of managers is performing relative
to the benchmark.
Consider the returns of the three managers Presidio has historically employed to manage
developed international equities. The three
couldn’t be more different: one is a classic stock
picker focusing on large cap growth, the other a
top-down thematic manager, and the final a deep
value manager who often hedges their currency
exposure.
The table below details their yearly performance
and that of the MSCI EAFE, the primary benchmark for their asset class. Outperformance versus
the index is noted by green shading, underperformance by red shading.
Table 2: Manager and index IRR and volatility†
Manager
Manager A
Manager B
Manager C
EAFE
IRR
7.5%
12.4%
6.7%
3.1%
Standard Deviation
26.0%
31.1%
21.3%
23.8%
Several things stand out about these performance
figures:
∗
Each manager had a significantly higher IRR
over the period than the index.
∗
The returns of each of the three managers
are fairly uncorrelated to each other.
∗
The returns of each manager differ greatly
from that of the index.
∗
Each manager has substantial and somewhat
random periods of under- and outperformance versus the index.
∗
The volatility of Manager A and B are
notably higher than that of the index.
A clear implication of the factors above is that an
investor would have been seriously inclined to
periodically consider one or more of his managers
either idiots or geniuses and reallocate accordingly. After all, a three or four year stretch of good
or poor relative performance would have likely
seemed convincing proof of the managers skill or
lack of competence.
Table 1: Annual Performance of International Equity Strategies†
Strategy
Manager A
Manager B
Manager C
EAFE
1999
2000
2001
52.0% â€7.0% â€11.5%
51.4% 29.0% â€17.7%
23.8% 25.3% 9.9%
27.0% â€14.2% â€21.4%
2002
2.3%
â€9.1%
â€17.1%
â€15.9%
2003
2004
2005
2006
2007
33.6% 18.7% 9.1% 23.0% 15.6%
28.7% 29.6% 40.3% 23.1% 43.4%
40.9% 9.6% 12.5% 21.7% 11.8%
38.6% 20.3% 13.5% 26.8% 11.8%
2008
â€45.9%
â€50.9%
â€40.2%
â€43.6%
2009
2010
2011
2012
(thru Q3)
50.0% 14.0% â€15.2% 10.3%
60.9% 16.7% â€17.6% 9.3%
22.3% 13.0% â€20.9% 11.5%
31.8% 8.2% â€12.1% 10.1%
Note: Manager returns are net of an assumed 0.65% annual advisory fee
† See disclosures section on last page.
4) PAGE 3
If, however, the investor had prudently maintained his discipline and rebalanced the
weightings of the three managers annually to the
50:25:25 ratio of Managers A, B, and C that
Presidio has recommended, his international
equity portfolio would have significantly outperformed the index with only slightly more
volatility. The IRR of the mix over the period
was 8.9% versus the index’s 3.1%, a whopping
5.8% of compounded outperformance. Note
that this assumes that the EAFE index can be
invested in at no cost – in reality all indexing
strategies have management fees (such as 0.35%
per year for the EFA ETF).
Strategy
Recommended Mix
EAFE
IRR
8.9%
3.1%
Standard Deviation
24.6%
23.8%
Figure 1: Growth of $1 (Mix vs. EAFE)†
$4.50
Growth of $1 †EAFE
Growth of $1 †Mix
$4.00
$3.50
$3.23
$3.00
$2.50
$2.00
$1.52
$1.50
$1.00
$0.50
$â€
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
It is interesting to consider the return that the
investor would have had if he been unable to
resist the temptation to reward historical performance. If every year after the first year the
investor had switched all his funds to the manager with the best performance in the prior
year, the IRR on his investment would have
dropped from 8.9% to 5.9%. Not only is this
much worse than he would have done with the
mix, it’s significantly lower than ANY of the individual managers!
The investor’s efforts to
identify the “best” manager from trailing returns
would have resulted in a loss of value versus a
more disciplined approach.
Table 4: Index and mix IRR and volatility†
A dollar invested in the EAFE index in 1999
would have resulted in $1.52 at the end of Q3
2012, whereas a dollar invested in the weighted
mix over the same period would have resulted in
a far greater amount, some $3.23. The mix’s
outperformance has led to a significant difference in the compounded return for investors.
Table 3: Performance of mix versus EAFE†
Strategy
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
(thru Q3)
Recommended Mix* 44.8% 10.1% â€7.7% â€5.4% 34.2% 19.2% 17.8% 22.7% 21.6% â€45.7% 45.8% 14.4% â€17.2% 10.4%
EAFE
27.0% â€14.2% â€21.4% â€15.9% 38.6% 20.3% 13.5% 26.8% 11.8% â€43.6% 31.8% 8.2% â€12.1% 11.0%
Mix Outperformance 17.8% 24.3% 13.7% 10.5% â€4.4% â€1.2% 4.3% â€4.1% 9.8% â€2.1% 14.0% 6.2% â€5.1% â€0.7%
* Recommended mix is 50% Manager A and 25% of each Manager B and C and is net of an assumed 0.65% annual advisory fee.
† See disclosures section on last page.
5) PAGE 4
CONCLUSION
Investing passively is easy, investing actively is not.
The former requires only the selection of a few appropriate indices and ensures average returns.
The latter requires far more, but offers the opportunity to capture significant additional returns.
If an investor decides to pursue an active approach, necessary skills include:
∗
The ability to identify managers who can outperform over time
∗
An understanding of what drives the manager’s return
∗
The ability to combine complementary managers within an asset class
to offset the effects of volatility
∗
The discipline needed to maintain exposure to managers during
periods of underperformance
∗
The patience needed to allow outperformance to come through
6) DISCLOSURES
PAGE 6
These insights come from Presidio Capital Advisors LLC, a SEC Registered Investment Advisory firm, is a subsidiary of The Presidio
Group LLC. There are no warranties, expressed or implied as to the accuracy, completeness, or results obtained from any information in this material. This white paper is provided for information purposes only. This document does not constitute an offer to
sell or a solicitation of an offer to purchase securities. Past performance does not guarantee, and is not necessarily indicative of,
future results. Index performance does not reflect the deduction of transaction costs, management fees or other costs, which would
reduce returns, thus investing in any money manager is not similar to investing in an index. References to market indexes or other
measures of relative market performance over a specified period of time are provided for your information only and do not imply that
money managers will achieve similar returns, volatility or other results. The composition of an index may not reflect the manner in
which a money manager’s portfolio is constructed in relation to expected or achieved returns, restrictions, sectors, correlations, concentrations, volatility, or tracking error targets, all of which may change over time. An investor cannot directly invest in an index. All
manager returns presented are net of the manager’s management fee. In addition, performance has been reduced by the amount of
the highest fee charged to any Presidio client employing that particular strategy during the period under consideration. Actual fees
may vary depending on, among other things, the applicable fee schedule and portfolio size. Actual client allocations may differ from
the Recommended Mix and is dependent on the client’s current portfolio holdings, risk level, and investment objective. Thus actual
client returns) may be different. Future relative performance of the Recommended Mix may or may not reflect historical performance. The performance represented herein for international equities is not necessarily representative of the performance of other
investments recommended by Presidio. Presidio provides broad advisory services to our clients but does not exercise discretion in the
selection of or relative allocation to managers. Diversification does not assure a profit or guarantee against a loss in declining markets. Presidio’s fees are available upon request and may be found in Part II of Schedule F of the Form ADV. The MSCI EAFE is the
primary benchmark for the composite and is a stock market index of foreign stocks. The index is market-capitalization weighted and
includes a selection of stocks from 22 developed markets, but excludes those from the U.S., Canada, and emerging economies. The
reported returns reflect a total a total return for each quarter inclusive of dividends.
The annual rates of return for Recommended Mix performance for the period 1999 through 2003 and the resulting performance statistics are hypothetical performance. Hypothetical performance does not represent the profit or loss resulting from actual trades. Rather, this hypothetical performance was generated by applying the weightings of the three managers to the target allocation of 50%
for Manager A, 25% for Manager B, 25% for Manager C utilizing the returns as specified in Table 1. Hypothetical performance results
have many inherent limitations, some of which are described below. No representation is made that any account will or is likely to
achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance
results and the results subsequently achieved by any particular trading strategy.
One of the limitations of hypothetical performance is that it is generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involved financial risk and no hypothetical trading record can completely account for the impact of financial
risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading
losses are material points that can adversely affect actual results. There are numerous other factors related to the markets in general or to the implementation of any specific portfolio program that cannot be fully accounted for in the preparation of hypothetical
performance results and all of which can adversely affect actual portfolio results. Timing of investment in-flows, out-flows, fees, and
deductions will impact a client’s portfolio.
Due to the differences between hypothetical and actual trading results and because management of the strategy described in this
white paper, there are significant inherent limitations in the hypothetical performance information presented herein. Accordingly,
customers should be particularly wary of placing any reliance on these results.
This material is proprietary and is not allowed to be reproduced, other than for your own personal, noncommercial use, without prior
written permission from Presidio.
This paper was originally published in 2010 and revised in November 2012.
© 2012 All rights reserved.