Improve your understanding to help clients move towards active management
One of the decisions that an adviser has to make is the investment company that he places his client’s retirement savings with. While this has a lot to do with the risk profile of the client, as well as their investment horizons, there are certain aspects of fund managers that advisers need to take note of before making this key decision.
The eternal debate in the industry is whether to advise your client to adopt an active investment strategy or a passive strategy. While passive seems to be the best approach to the market at the moment, there is a place for active strategies in the world; but how does one go about selecting a capable active manager? One that takes the right amount of acceptable risk?
A lot has been said about the apparent poor performance of South African active fund managers when compared to their international counterparts, so the specific skill set of fund managers need to be placed under the microscope.
The cornerstone of trust
Trust is a key component in the industry, but it is essential that it is not given lightly. At the end of the day, if all goes downhill, your clients will turn to you for answers. So where does one place trust?
Perhaps a good place to start is right at the beginning. With those who stand to lose the most in these situations. Deslin Naidoo (CFA), Head of Investment Research and Product Development at Alexander Forbes, points out that Boards of Trustees do not select active equity managers in isolation. Before managers can be selected, boards need to identify what outcome they want their portfolios to achieve. “From this desired outcome, the board will identify the asset allocation for their portfolios and the benchmarks for each of the asset classes in the asset allocation.
So it is safe to say that Boards of Trustees also wrestle with the decision of active over passive, or vice versa. “Using an active equity manager provides the possibility of either improving the returns of the portfolio or reducing its risk, preferably a combination of both. The value of an active equity manager lies in their ability to harvest the equity risk premium on a better risk return basis than the benchmark,” says Naidoo.
Don’t ignore beta
It is natural for active fund managers to do their best to achieve alpha. But this does not mean that they must ignore beta. In order to achieve alpha, one needs to assume a certain amount of risk. In order to generate additional return, one needs to assume risk. Some of this risk can be averted, but some of it needs to be absorbed.
Fund managers need to understand that their quest for Alpha simply cannot overshadow the portfolio’s need for beta. Trevino Ramsamy, Head of Alexander Forbes Investment Surveys, points out that the reality is that the only way to gain alpha is to differ from the benchmark in some way, which means potentially compromising on the beta. “Trustees need to be aware of this trade off so that they can appropriately select and blend managers in their equity strategy,” says Ramsamy.
By blending managers, funds seek to reduce, not amplify, risk. “The purpose of selecting multiple equity managers should be to diversify manager investment approaches to assume the right balance of risk in the fund that maximises the probability of getting a consistent positive alpha through different market cycles over the long term. The performance of the fund should be generated from risk that has been internally assumed,” says Ramsamy.
Evaluate performance
Once the manager’s philosophy and process is understood, their portfolios need to be examined. Naidoo says that the test of a good manager is that they can translate their philosophy into their portfolio construction and that they get their performance from those areas where they consciously chose to take on risk.
The key question to ask here is if a manager acts with conviction. Conviction is an expression to generally describe how the manager choses to implement their views on stocks in their portfolio. “Managers who have high conviction – usually non-benchmark cognisant managers – would be more aggressive in implementing their view by holding less stocks and have more concentrated positions. Benchmark cognisant managers would tend to hold more shares with smaller active positions,” says Naidoo.
The role of the adviser is key in explaining the need for risk and beta in the growth of a fund. By nature, humans are risk averse and would rather see growth than stagnation. However, a certain amount of risk is needed for the fund to grow. Perhaps sitting with a client and engaging with them on the nature of the risk that the portfolio will be taking on will build trust. Perhaps the risk that the fund wants to take on is risk that clients are not prepared to take. The adviser then needs to assess the strategies of fund managers in order to see if they are taking on the right amount of acceptable risk or if their strategies are not suited to their clients.
Editor’s Thoughts:
Investing is not an exact science, and explaining this to clients can be an arduous task. But in a world where clients are encouraged to gain more insight into the industry, it is necessary for them to understand risk and how it can be beneficial to them. If this is not achieved, clients will favour passive investing as a go to strategy when they could significantly benefit from active management. Please comment below, interact with us on Twitter at @fanews_online or email me your thoughts [email protected].
