How to deliver superior returns in difficult markets
How to deliver superior returns in difficult markets
“To achieve real, robust returns, it is important to build efficient portfolios that contain a combination of more aggressive stock-selection strategies, balanced with index tracking strategies. It is only the ratios that differ…” says Patrice Rassou, Head of Equities at Sanlam Investment Management
As we pass the halfway mark of yet another turbulent year, we reflect on the generally poor returns across local asset classes and increasingly correlated markets. Currently, markets are delivering below inflation returns and asset owners are not sufficiently rewarded with a premium for taking on additional risk. In light of this, we attempt to address the ongoing challenge carried by trustees and principal officers.
As a fiduciary, how can you build optimised portfolios and generate strong risk-adjusted returns for your retirement funds, in tricky market environments? How do we find returns that are less correlated with more benchmark-cognisant funds, without taking excessive risk?
Says Rassou, we need to look at how we can use smarter portfolio construction techniques to eke out positive (real) returns for clients in tricky markets. The underlying rationale for our solution is premised on cross-sectional volatility (CSV); considered a good indicator of the potential outperformance of markets for active managers to exploit.
What is cross-sectional volatility?
Explains Rassou, unlike a measure such as the VIX (fear) index, which measures the volatility of an entire index (S&P), cross-sectional volatility (CSV) measures the difference in volatility between stocks in an index. This more granular approach allows for a better understanding of the variability of (or dispersion between) individual stock returns and an active manager’s true skill.
The basic argument is that as CSV rises, the likelihood of outperformance of the market and other active managers increases, because the variance between the best and worst-performing shares is great, which should be beneficial to a discerning stock-picker. However, in an environment of low cross-sectional volatility, the likelihood of outperformance falls, making it much harder to beat other active managers (and the market). In this instance we should have a bias for a simple indexation (market tracking) strategy.
In the chart below, we show a retrospective view of several cycles from 2008 to 2017. It illustrates the relative over and under-performance of a superior stock picker’s strategy (using the Sanlam Investment Management (SIM) Top Choice Equity Fund as an example) over the past ten years during times of high and low dispersion of returns (or high and low CSV).
Figure 1: Correlation between high CSV and outperformance through a stock-pickers strategy
Let’s reflect on the cycles illustrated in the graph above.
Global financial crisis (Cycle 1)
Immediately after the Global Financial Crisis, the market dislocation that followed allowed discerning stock picking managers to pick up quality stocks that were sold off indiscriminately, resulting in massive outperformance in the second half of 2008 (refer Cycle 1: 2008 – 2010 in graph above).
But as central banks around the world started pumping liquidity into financial markets and equities recovered at the start of 2009, dispersion in returns fell – which meant that all stocks started recovering irrespective of the underlying fundamentals of the companies (i.e. correlated markets). This decline in volatility made it more difficult for a stock picking fund to differentiate itself.
Taper tantrum (Cycle 2)
As can be seen over the 2011/2013 cycle, the volatility of stocks started rising again. This was due to the risk of Greece exiting the European Union, which shook financial markets globally, and a series of ‘taper tantrums’ leading to further dislocations in financial markets as investors started to worry about when the aggressive printing of money by central banks would start winding down. In this environment of rising volatility, stock picking funds such as the SIM Top Choice Equity Fund were able to deliver strong alpha.
Lower cross sectional volatility (Cycle 3)
As we entered 2014 and through to 2017, volatility once again flattened out as it became clear that the EU would survive in its present shape and the market was reassured that liquidity would remain plentiful globally. As the dispersion of stock returns declined, so the opportunities to deliver alpha declined and it became more difficult to beat the market, although some outperformance was evident.
How to build efficient portfolios in the current environment
Now, we could potentially be entering a new cycle of either rising or falling dispersion in stock returns. In the absence of a crystal ball as to what the next cycle will hold, we propose a simulation exercise to capture two potential scenarios.
Says Rassou, we need a balanced approach that will include the optimal combination of (higher risk) stock-picking strategies to deliver outperformance, and (lower risk) index-tracking strategies that will produce market-like returns. The quantum and ratio of each will vary dynamically depending on how conducive markets are.
Simulation exercise to achieve outperformance
Extrapolating the lessons learned above, one would need to switch dynamically between two possible strategies depending on market conditions and dispersion of returns (outlined below).
Scenario One: Rising dispersion of stock returns (high cross-sectional volatility)
Let’s assume a scenario where the rate of dispersion in returns is high or rising. In this scenario we consider it to be a stock-pickers paradise, and one should therefore show a bias for a more aggressively-concentrated stock-picking strategy, with a lesser allocation to indexation components. This way, investors can extract superior results by exposing themselves to the alpha-generating capability of a stock-concentrated portfolio, while also lowering costs and volatility. For the purposes of this exercise, we use the SIM Top Choice Equity Fund to represent an aggressively-concentrated stock picking fund.
Proposed tactical solution: Blend SIM Top Choice Equity Fund (75%) with an index fund (25%)
Scenario Two: Declining dispersion of stock returns (low cross-sectional volatility)
Assuming an environment of declining stock dispersion, here you would reduce your relative exposure to an aggressively concentrated fund and increase your exposure to a cheaper indexation strategy. A slightly more diluted tactical blend would then apply.
Proposed tactical solution: Blend SIM Top Choice Equity Fund (50%) with an index fund (50%)
As can be seen from the chart below, blending the SIM Top Choice Equity Fund as per the scenarios above reduces the volatility of the blended fund well below that of the market, while still outperforming the market handsomely. In addition, a blend with an index fund would also reduce the cost of the blend, paying a lower cost for beta when dispersion in stock returns is low and only paying for performance when alpha is delivered in high dispersion environments.
Source: Sanlam Investment Management, July 2017
To build optimised portfolios and ensure robust returns, a balanced approach is required. An aggressive stock-picking strategy can be optimally combined with a simple index fund to extract superior results by exposing an investor to the fund’s superior alpha-generating capability when the market is more conducive (ie when CSV is high and rising). Similarly, when CSV (the rate of change of dispersion) is falling, one would reduce exposure to a stock-picking strategy and increase exposure to a cheaper index fund.
The advantage of including an index fund in the blend is that it reduces both the volatility and cost of the blend, paying a lower cost for beta when dispersion in stock returns is low and only paying for performance when alpha is delivered in high dispersion environments.
An aggressive stock-picking capability such as SIM Top Choice Equity Fund is made up of the best ideas of the equity portfolio managers at SIM. Now, as central banks are poised to raise rates, could dispersion of stocks rise again? If so, this could see the fund well poised to capture more of the alpha opportunities as they arise in future.
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