This article has been written by Dan Kemp, head of investment consulting and portfolio management, EMEA, Morningstar. It initially appeared on Morningstar's U.K. website.
The rise of strategic beta strategies is causing an existential crisis for active managers in developed markets. These semi-passive strategies have systematised many of the sources of outperformance formally attributed to fund manager skill, encouraging us to ask: could strategic beta funds lead to the demise of active management.
While strategic beta funds undoubtedly pose a challenge to active management, accessing the superior returns offered by these strategies is more difficult than simply purchasing a strategic beta fund. Many of the strategies exploited by these funds require a great deal of discipline to consistently implement; a responsibility that falls to the fund holder.
In a recent paper, “Dimensions of Popularity”, published in the Journal of Portfolio Management and co-authored by my colleague Tom Idzorek, Head of Investment Methodology and Economic Research at Morningstar, and Roger Ibbotson, Professor in the Practice Emeritus of Finance at Yale, Tom and Roger show that many of the ‘risk premiums’ identified by academics over the past 30 years can be gathered together under a simple heading of ‘unpopularity’.
While strategic beta funds and active fund managers often try to exploit the superior return generating characteristics of unpopular investments such as low beta, smaller companies and value stocks etc., the key driver of outperformance is the ability of an investor to buy unpopular stocks and to continue to own them for the right amount of time.
Few investors are able to do this consistently, preferring to herd together in popular stocks. As a consequence, investors tend to miss the outperformance potential of unpopular stocks and overpay for the popular ones.
However, while some investors are indeed prepared to consistently buy unpopular stocks, few have the discipline to own these stocks long enough for them to bear fruit. This is because investors typically underestimate the time required to realise the gains from holding an unpopular position and are therefore ill-prepared to maintain a contrarian strategy.
Unpopular stocks and assets can underperform for years before delivering superior returns, and while the eventual outperformance typically outweighs the prior underperformance (presenting the ‘risk premium’), there are few professional investors who are permitted to underperform for such a period and yet retain their job.
The success of a long-term contrarian approach is demonstrated by research undertaken on ‘active share’ by Martijn Cremers. This shows that high active share alone is not a reliable predictor of returns, but rather it is the combination of high active share and low turnover. When seeking a portfolio manager it seems it pays to look for patient contrarians who are secure in their job.
We might conclude therefore that while the emergence of strategic beta strategies pose a challenge for active managers, they are unlikely to improve returns for the end investor. The key obstacle preventing investors from accessing known sources of excess returns is not a lack of skillful fund managers, but a lack of patience on the part of the investor. Only by assigning long-term mandates and removing the career risk from talented fund managers can we hope to generate superior returns for our investors.
