From CIO to CIO – the message is the same. There will be more volatility and extended periods of lackluster returns. Dropping hedge funds months back, the California Public Employees’ Retirement System (CalPERS) will eventually (don’t know how long) move its discount rate from 7.5% to 6.5%. Smart beta, otherwise called factor-based investing, can assist institutional investors on their quest to reach target returns, but active management can play a major role in providing extra juice. The debate on the efficacy of active equity management remains tense. Statistics do not lie, as the usage of exchange-traded funds (ETF) among institutional investors increased over the decade. In addition, a number of academic studies have illustrated the difference in performance from the top manager and average manager in large-cap U.S. mutual funds narrowing. In my opinion, investors need to rethink Modern Portfolio Theory and not let the constraints of the past be the drivers of the future. Assumptions can be dangerous and proved to be so during the global financial crisis. As a financial commentator and president of a research company on asset owners, I will [try to] avoid being pessimistic in the remainder of this article and focus on the future strategies.
Alpha is Out There
Despite rhetoric, in my opinion, finding alpha has never been easy. It is risky, time consuming and can be expensive. Fortunately for me, the peripatetic nature of my job, allows me to get perspective on alpha from a wide range of institutional investors. From the shores of New Zealand, to the streets of Ankara and to the Toronto skyline, the generation of alpha is occurring. Skilled managers and asset owners are discovering streams of alpha, at times employing complex strategies. Notable hedge funders like Bill Ackman are backed by pensions, endowments and other asset owners. Ackman runs Pershing Square Capital Management which recently increased its stake in Canadian pharmaceutical company Valeant Pharmaceuticals from 5.7% to 9.9% according to an SEC filing. Ackman’s alpha is his concentrated bets. Yet despite U.S. Democrat Presidential Candidate Hillary Clinton tweeting disgust on pharmaceutical price gouging or a nasty short-seller report from Citron, Ackman could generate serious alpha if Valeant’s stock turns around.
In our upcoming January 2016 issue of The Sovereign Wealth Quarterly, there will be a focus on alpha and some of the sources where asset owners such as wealth funds, pensions and endowments are harvesting it. I’m not advocating allocating wads of cash to a flashy hedge fund, but what I am trying to illustrate is that there are large asset owners beating the benchmark. This could be internal management timing strategies, finding “alpha hunters”, concentrated portfolios, small-cap stocks, or even investing in niche industries in frontier markets. Today, there are plenty of asset managers generating alpha for their clients despite what people say. Finding the right manager and monitoring them is another story. However, with the right incentives in place, these managers can be indefatigable hunters of alpha. For example, we are witnessing through SWFI Compass (our RFP and opportunity service), an increase in demand for skilled, active, small-cap managers. Small-cap stocks can offer a higher risk premia, due to factors such as volatility and trading costs.
However, there are shortcomings of discovering alpha sources whether through a skilled manager (eventually people find out) or on one’s own efforts. Alpha is not sustainable – investors, the market eventually finds out. How many times can the Seattle Seahawks quarterback Russell Wilson carry the team to NFL championships? Great ideas get copied. Furthermore, as wealth funds and pensions get bigger in asset size, the contributory effect of alpha strategies in their total portfolio return could diminish.
We are not going to bore you with investment models and endless empirical literature on whether alpha is dead or not. We are going to cover themes and strategies used by asset owners to generate “alpha” or bits of it at least.
Here are 5 themes on alpha, SWFI staff wants to highlight (not necessarily in this order):
- 1. Small-Cap Stocks (Active Management)
2. Becoming a Lender and Other Credit Opportunities
3. Insurance-Linked Securities and Catastrophic Risks
4. Selecting Skilled Managers
5. Activist Strategies and Concentrated Portfolios
The views in this article are expressed by Michael Maduell.
Michael Maduell is President of the SWFI.
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