JASON TEH, Chief Investment Officer |
Exchange traded funds (ETFs) and passive investing are disrupting the active funds management industry. While passive funds have been around for decades global flows into ETF assets have recently surged past US$4 trillion. Australia’s ETF market is a fraction of the world at around A$90 billion and is expected to grow rapidly.
ETFs are popular partly because they empower financial advisers and investors to take greater control of assets rather than relying on active fund managers. Do you need a value manager if you can buy a value index ETF such as Vanguard Global Value Equity Active ETF? Or do you need a growth manager if you can buy a Nasdaq Index ETF such as Invesco QQQ Trust?
Nowadays the list of ETFs seems quite endless. Investors have more flexibility to implement their desired investment exposure to an asset class, sector or factor (such as growth, value, quality and so on – typically called smart beta ETFs).
- If you want 100% market exposure to an asset class, sector or factor you can buy an ETF that mirrors that index. This portfolio has an index sensitivity (beta) of 1, which moves as much as the index.
- If you want potentially greater returns, which comes with greater risks, you can buy an ETF that is 50% geared or is 2x levered to the index. This portfolio has a market sensitivity (beta) of 2, which moves twice as much as the index.
- If you can’t tolerate the index risk, you can just blend cash with the ETF in a portfolio. This portfolio has an index sensitivity (beta) of less than 1, which moves less than the index.
If betas are so easy to obtain using ETFs, is there still a role for active fund managers?
Excess return and alpha confusion
You would think that a fund delivering poor excess returns could be replaced with an ETF portfolio. However, excess returns are not the best way to measure and screen your manager. And problematically, sometimes active managers highlight their value-add to the market by describing their excess returns as alpha. Excess returns and alpha are not the same thing.
Excess return is simply the difference between a fund’s total return and market return. It is always influenced by how much risk the manager takes relative to the market (beta). Alpha, on the other hand, measures pure stock picking skills and is part of the return not related to the market.
Let me explain further by deconstructing the total return of an actively managed fund into two components:
Fund Total Return = market related return + non-market related return
______________________market return x beta + alpha
Most funds have a beta related to the market. Overweight positions in more volatile stocks tend to increase the fund’s market sensitivity (beta) and vice versa. For example, a high-beta manager would have likely outperformed the bull market in 2019 but underperformed during the market correction in late 2018. By the same token, a low-beta manager would have likely underperformed in 2019 but outperformed in the fourth quarter of 2018.
Beta matters in an ETF world because a portion of your active managers’ total return can be replicated cheaply. However, ETFs cannot deliver the other component of total return – the non-beta related return called alpha.
Because there are two components of return it is possible for a high beta fund to deliver high excess returns even though its alpha is poor in a strong rising market: the rising tide lifts all boats. For example, in 2019 when the Australian equity market returned 24%, an active manager that swung for the fences (beta of 2) but had poor stock picking skills (alpha of minus 10%) would have still generated an exceptional 38% return. This extraordinary result would have generated a 14% excess return above the market despite the manager’s poor skill.
Now consider the alternative in an ETF world. An investor could have invested in Beta Shares Geared Australian Equities ETF (GEAR), which is designed to have 2 times the beta of the market, replicating the active fund’s risk profile. In 2019, GEAR delivered a whopping 52%, which far exceeded the returns of the high beta manager with negative alpha. The ETF clearly did a better job than the fund manager.
For the same reason, it is also possible for a low-beta fund to underperform in a fast, rising market despite delivering good alpha. In this case, the manager performs better than an ETF portfolio with the same risk profile.
Hence, using excess returns to screen fund managers may provide false signals. Assessing a fund managers’ skill in the short term based on excess returns is difficult, as Howard Marks recently alluded to in his recent memo:
“In the long run, superior skill will overcome the impact of bad luck. But in the short run, luck can overwhelm skill, and the two can be indistinguishable”
Howard Marks, You Bet! Memo, Oaktree Capital Management, January 2020
In the short term, excess return and alpha can diverge depending on the market environment. Skill and luck can be indistinguishable when assessing excess returns. Less skilled managers can get lucky in any single year and generate excess returns through their beta exposure. In strong bull or bear markets, their beta tends to dilute the impact of their alpha even more.
In the long term, excess returns and alpha tend to converge because superior skill will overcome the impact of bad luck. In other words, the alpha of skilled managers is not diluted by the general movements of markets from year to year. Note that the word ‘tend’ is emphasized because an active manager that delivers the same return as the market (0% excess return) but with half the risk is still a very strong alpha generator. Who wouldn’t want equity like returns with half the risk?
Finding alpha managers
Because fund betas are not widely disclosed many investors assume that all active managers have the same risk (beta of 1) as the index. Hence, the 14% excess return from a high beta manager in a strong bull market (like in the previous example) may not give the full picture. In fact, Ray Dalio, a well-known US hedge fund manager, is scathing of active funds that deliver returns that are effectively beta exposures to an asset class – even if they outperformed the market..
Rather than use excess returns to determine whether a manager is skilled there is a better method. Simply, rearrange the above formula, find out your fund’s beta and then solve for alpha.
Alpha = Fund return – Market return x beta
High alpha managers can spot greater market inefficiencies and the risk required to extract that return. Hence, calculating the fund’s alpha will reveal whether a manager is skilled in capturing market inefficiencies. That is, delivering a return greater than the risk taken. When risk is normalised, high alpha managers tend to deliver higher risk-adjusted returns or more return per unit of risk. The following chart highlights the linear relationship between alpha and risk-adjusted returns for high income funds.
This relationship can be measured across different categories of active funds such as such as low-income funds, long/short funds, long only funds, infrastructure funds and so on. The results should reveal whether fund managers are skilled or just hiding behind their beta. If managers are hiding behind their beta exposure, perhaps they should be replaced with an ETF portfolio. On the other hand, if a manager is delivering consistent alpha or high risk-adjusted returns, there may be less reasons to replace them with an ETF portfolio.
The growth in ETFs is set to continue partly because investors feel empowered when they have greater control of their assets. ETFs provide an easy way to access any asset class, sector or factor thus replicating the beta exposures of most active funds.
There is a common misconception that all funds have the same risk profile as their underlying benchmark. Hence, using excess return as a guide to replace a fund manager with an ETF may not lead to an optimal outcome. Excess returns do not adjust for risk hence is a very blunt tool to assess manager skill. When risk profiles are normalised, true manager skill or alpha is revealed.
Alpha and risk-adjusted performance should be the most important criteria investors use to choose active funds. This is the key to understanding why ETFs can effectively act as part of the portfolio solution, but not always the complete solution. ETFs can only deliver returns purely as a beta exposure to the market, sector or factor. ETFs are not designed to deliver high risk-adjusted returns versus the underlying index – this is the job for a skilled active manager. Delivering alpha is the only way active managers can survive and likely thrive in an ETF dominated world.