Happy Holidays! In the spirit of celebration, I’d like to give you what I know you all were hoping for: an update on our current research. As I mentioned in the title, this is a very exciting time to be in the investment community. Industry advancements are creating opportunities that could improve the return and/or risk characteristics of a portfolio. How so? Empirical evidence is expanding the broader understanding of sources of return and new products are allowing investors to access these sources of return. We’re going to cover these changes (understanding sources of return and accessing returns) before reviewing how APCM is evaluating these products on a portfolio and fund level.
Understanding Sources of Return
Since the development of the Capital Asset Pricing Model (CAPM) back in the 1960s, returns have been parceled into beta (returns associated with the general market) and alpha (a manager’s added value above the market return). This is called a one factor model because the market is the only “factor” that is explaining the return of a portfolio, so any excess return should be attributed to the manager. Beta is readily available, low cost, and does not involve security selection skill. Alpha tends to be difficult to identify, rare, expensive, and lacks persistence through time.
So what’s changing? Academic research is demonstrating that much of what was considered alpha, or returns above market, can actually be attributed to alternative factors (a characteristic relating a group of securities that is important in explaining their risk and return). A common example of a factor is size. Small companies have been shown to outperform large companies over a long time horizon as investors require additional compensation because of the increased risk associated with these firms. A manager who is benchmarked to the S&P 500 (U.S. Large Cap stocks) could add incremental performance by investing in smaller companies (like the S&P 400 U.S. Mid Cap stocks or S&P 600 U.S. Small Cap stocks). This manager is taking advantage of a known risk premium to enhance performance, not necessarily picking better stocks.
What’s really interesting is that factors do not just apply to stocks. Much of the alternative investment space (particularly hedge fund strategies) also have returns attributed to beta. Some of the returns that are uncorrelated with market risk, such as merger arbitrage (buying stocks that are being purchased by another company), are associated with a risk premium that can be accessed without manager skill.
So what does this mean for your portfolio? While factor investing has been around for a while (think Warren Buffet’s value investing), these returns have traditionally been accessed through an active manager. However, financial innovation is driving product development that allows investors to access these same sources of return, but in a rules-based, transparent investment vehicle at lower fees. I told you this was exciting! You can already see this concept with one of our U.S. Large Cap funds that emphasizes earnings quality, which is another academically identified factor.
Portfolio and Fund Evaluation
Not to take away the punch bowl right as this factor party was getting started, but identifying a new investment is just one part of our research. We also need to determine if it belongs in your portfolio as either a return enhancer or a risk diversifier. Brandy always reminds me that you need to consider how an investment impacts the entire portfolio, not just analyze it on a standalone basis. When evaluating an investment opportunity, APCM has a duel approach: inclusion and accessibility. The decision to include an investment can be quantitively based on the expected return and risk values and the correlation of the investment to the overall portfolio, per the following formula.
If the investment meets the criteria for inclusion in a portfolio, we then evaluate the accessibility of the investment. Essentially, does the investment still benefit the portfolio after implementation costs?
We are currently applying these evaluation tools to three areas: Private Equity, Infrastructure, and Hedge Fund Beta Strategies. Our team’s analysis will be complete in the Spring of 2018 and we look forward to sharing our conclusions with you then!