Is your fund manager charging for skill or excess risk

CAPE TOWN – In South Africa, investors have grown to accept that a fund manager’s job is to beat a benchmark. And if they do that, we think that it must have taken some particular skill to get there.

We have therefore created an investment culture that lives on past performance. Our primary, and sometimes only, measure of a manager’s skill is their performance track record.

However, the head of Barclays Risk Strategy Group, Roland Rousseau points out that skill is not a pre-requisite for beating a benchmark. For instance, any portfolio in South Africa that held more than 40% in equities would have beaten CPI+6% since 1999.

In a similar vein, if anyone wanted to outperform a composite benchmark that was 50% the FTSE/JSE All Share Index, and 50% the FTSE/JSE All Bond Index, all they would have to do is allocate 60% of the portfolio to an All Share Index tracker and 40% to an All Bond Index tracker and forget about it. Taking the extra risk by investing more of the portfolio into equities would result in a higher return.

“What drives performance is not skill, but the risks the manager is taking,” explains Rousseau. “The manager doesn’t make risk. They just expose their clients to various kinds of risk.”

Rousseau argues that it is critical that investors understand this, and appreciate what kinds of risks their fund managers are taking.

“In equity, the Fama-French model says that risk, and therefore performance, comes from four factors – small caps, momentum, value and the general market,” he explains. “None of these four things should be deemed skill, because anybody who buys them will get that risk premium.”

He points out that any equity manager who buys value will get that risk premium, regardless of skill. Just as any balanced fund manager who loads up on equity will get that risk premium. To understand the true skill of the manager, therefore, you have to strip out these factors.

“If there is any excess return left after taking out these risk premiums, then that must be due to stock picking and market timing, which are the only two sources of skill,” Rousseau says. “That tells you, after risks, what the manager did.”

If the manager simply beat the benchmark because he took on extra risk, that is not a sign of skill. In fact it is the opposite, because those same risks can turn against you. A good manager is one who delivers returns over and above the risks taken.

“You might think that the managers at the top of the performance rankings are the most skilful, but when you look at the risks they have taken, they are also likely to have taken the most risk,” Roussea says. “And you’ll find that the managers at the bottom of the rankings also took a lot of risk. They just took the wrong risks at the wrong time.”

An obvious example at the moment is the incredible outperformance of deep value funds over the last few months. Since the start of the year, they have shot the lights out.

For the 18 months before that, however, their performance was dire. They were at the bottom of the pile.

The important thing to understand is that throughout this period they were taking exactly the same risk. It counted against them for a long time before it turned in their favour.

“They all did badly at the same time and now they are all doing well at the same time because they are all doing the same thing,” says Rousseau. “And if they are all doing the same thing with the same risk, it’s not them that’s responsible, it’s the risk. They are selling you excess risk, not excess return.”

This, he says, is why in other parts of the world there is a growing trend towards using technology to develop strategies that do not manage a fund towards a return target, but a risk target. The key is a dynamic asset allocation that does not look to the past or the future, but assesses the current market conditions and which risks are most appropriate to take.

“We are moving from a return management environment to a risk management environment,” Rousseau says. “Neither active nor passive funds are currently able to adapt to changing market conditions efficiently. You need a different portfolio in different regimes, for instance in times of high volatility and low volatility. At the moment you just have to sit through it while the market is all over the place. But why not de-risk? We have the technology to do it.”

This he believes is the future of asset management, as the tools are now available to ‘x-ray’ portfolios to understand exactly what risks managers are taking, and how these contribute to performance. These give investors better means of assessing their managers, which Rousseau believes will lead to them demanding more from them.

“We can’t all outperform,” he says. “It’s a zero sum game. But we can all lower our risk and lower our costs simultaneously. At the moment we’re all going to the casino thinking we’re all going to come out winners, but perhaps in the near future we will pay fund managers to lower our risk, not try to beat benchmarks by constantly delivering unnecessary excess risk.”

Roland Rousseau was presenting at the 2016 Investment Intel conference hosted by Glacier by Sanlam and Sanlam Investments.

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