Equities have delivered strong returns since the market bottomed in March 2009, making beta exposure more than sufficient for many investors to achieve their return targets. At the same time, active managers on average have trailed equity indexes, leading some to raise skepticism about the benefits of active management versus passive market indexed strategies.
Looking forward however, with sluggish global growth likely leading to modest earnings growth, we expect equity returns to be meaningfully lower than the past few years, and alpha to be increasingly important in equity portfolios. While PIMCO’s New Neutral thesis of low real interest rates for the long term is supportive of current fuller equity market valuations, for the road ahead, beta may not be enough: Achieving alpha from equity allocations will likely be necessary for investors to meet their return objectives.
There are impediments but also solutions to harnessing equity alpha
The challenge for many investors is there are a number of reasons their equity portfolio may not be positioned to achieve alpha, including:
- Large allocations to passive market cap weighted strategies which, by design, modestly underperform the market after fees and transaction costs
- Benchmark hugging active equity managers, who have difficulty outperforming after fees
- A portfolio construction framework comprising too many strategies, essentially creating expensive equity index exposure
- A manager selection process that leads to poorly timed hiring and firing decisions, and an insufficient time horizon that doesn’t allow for style headwinds to mean revert.
Such structural impediments to performance have not necessarily been problematic in the recent environment of high equity market returns and low volatility. But facing an environment with lower expected returns, and potential for bouts of volatility, how can investors find the alpha needed to enhance market returns and make the most out of the equity market risk they are underwriting?
Investors may need to look beyond traditional active or passive approaches in order to capture equity alpha. At PIMCO, we believe there are several independent and complementary sources of alpha that investors can access to help outperform the broader market. These “building blocks” of equity alpha include high active share stock selection, smart beta-based strategies and portable alpha approaches.
High active share stock selection
As our industry has become more focused on tracking error and relative returns, active managers are taking less active risk, which is evident in the steady decrease in the percentage of equity strategies that have high active share (the percentage of holdings in a portfolio that differ from the benchmark index). Sizing positions based on research conviction rather than benchmark weight typically results in high active share, which is an important indicator of the potential for outperformance. This stands to reason as a manager who emphasizes their positions of highest conviction – regardless of benchmark representation – should produce superior results over the long term if their convictions are well founded. So, while the average active equity manager may underperform, multiple studies have shown that the average high active share manager outperforms after fees. In a recent Cambridge Associates study, institutional managers were grouped into quartiles by active share, and the results showed the average highest-quartile active share manager outperformed the lowest-quartile active share manager over a time period that includes both bear and bull markets (Figure 1).
Smart beta-based strategies
There are a range of views on the term “smart beta” and whether these systematic, rules-based approaches to achieving market outperformance should be viewed as active or passive. Regardless of the terminology used, there is a very logical basis to why these strategies may outperform the market across periods of reasonable length. By design, smart beta strategies take a valuation indifferent approach to portfolio construction. In breaking the link between stock price and portfolio weight, smart beta strategies avoid the performance drag inherent in capitalization-weighted indexes that necessarily overweight overpriced stocks and sectors and underweight underpriced stocks and sectors. Assuming the stock market is not perfectly efficient – think the Japan bubble in the ‘80s, technology in the ‘90s or financials in the ‘00s – smart beta strategies seek to avoid the ultimate, and sometimes quite painful, re-pricing of stocks and sectors in an effort to reflect more realistic economic value. One well regarded example of a smart beta approach that has consistently and meaningfully outperformed the market by capitalizing on these observable market inefficiencies is the Research Affiliates Fundamental Index (RAFI), which selects and weights stocks based on company sales, cash flows, book value and dividends (Figure 2).
Another way for equity investors to capture sources of excess return is through a portable alpha approach. Rather than obtaining equity exposure by purchasing common stocks, portable alpha strategies obtain equity exposure synthetically, typically via futures or swaps. The economic exposure is very similar to owning the underlying stocks – the difference lies in the payment structure. With a common stock portfolio the payment is made at time of purchase. In a portable alpha strategy, instead of up-front payment, there is a money-market rate financing cost associated with a futures and swap-based stock portfolio. This method of gaining equity exposure allows the manager to run an independent, complementary strategy designed to generate alpha in addition to receiving the returns of the equity portfolio. In essence, if the returns of the alpha strategy exceed the money-market cost of the equity exposure plus management fees, then the strategy overall will outperform (Figure 3). For example, in a portable alpha equity construct an absolute return oriented bond alpha strategy may capture persistent, structural return opportunities relative to a money market rate and at the same time provide equity risk diversification benefits.
Structuring an equity portfolio for higher returns
Investors can utilize these building blocks of equity alpha as a guide to hire managers and select strategies, and they can potentially improve returns by putting them together using an enhanced core/satellite framework. Traditionally, core/satellite portfolios have had passive at the core and a collection of active managers as satellites, which depending on manager selection may or may not have generated alpha. In the recent environment, this construct generally delivered sufficiently high returns just on the strength of the beta component. But for the environment ahead, we think investors need to be more thoughtful in structuring their equity portfolio in order to capture alpha from both their core and satellite allocations.
To enhance this framework, we believe it is important that the core of the portfolio continues to have economically representative and diversified equity exposure. Rather than traditional passive, however, implementing this exposure with smart beta-based and/or portable alpha equity approaches provides the potential for meaningful and valuable alpha (Figure 4).
One of the benefits of both smart beta-based and portable alpha approaches is the potential for excess returns that are structural in nature. The inclusion of these alpha generating core strategies can be helpful not only in providing additional diversified sources of return but also in allowing adequate time for the realization of the longer-term value proposition of skilled high active share managers with disciplined investment processes and high quality research. In addition to incorporating high active share strategies, we believe satellite allocations should be diversified across investment styles, such as value, growth, and outcome-oriented approaches like dividend income, low volatility and long/short equity strategies. The combination of high active share satellites with a smart beta and portable alpha core may contribute to more consistent and more meaningful alpha generation from investors’ equity allocations overall.
Equities will always be an important part of investor portfolios given the returns they provide over the long term. But after a very strong run for the equity markets, the road ahead suggests a lower return environment and the need for alpha. By clearly identifying the repeatable drivers of equity alpha – the building blocks – and structuring equity allocations within a disciplined framework, investors can pursue the returns needed to help meet their objectives.