The focus on true alpha

16 October 2019

LTIIFocusOnAlphaHighlight

Michael Blair, Head of Investment Risk and Portfolio Analytics, on why a focus on quality can capture long-term value.

Capturing Long-Term Value

Martin Currie believes that stocks with a long track record of high economic returns converted to strong cash flow generation, supported by enviable and defendable business models, deliver consistent and attractive long-term returns to shareholders that are superior than the market. The market is, by its nature, short term and speculative. Consequently, it fails to adequately capture the true long-term worth of such stocks as they compound their value year after year, decade after decade.

The quality back-test

This is something we and others have evidenced in a number of long-term, empirical studies. In our own analysis, which we commissioned from an independent research provider, we looked at global and international equities over the 30-year period to June 2014. For this purpose, we emphasised value creation by creating a hypothetical strategy that only included stocks where the last reported return on invested capital (ROIC) exceeded cost of equity (COE) as at 30 June each year during the preceding 10 years. The results are shown in the table below.

Equal weighted strategy universe and quintiles
Market Strategy Q1 Q2 Q3 Q4 Q5
Ann, return 5.0% 8.7% 6.9% 6.6% 8.4% 10.5% 10.3%
Ann, risk 17.5% 14.4% 17.6% 14.5% 15.2% 14.4% 16.0%
Return/risk 0.28 0.60 0.39 0.45 0.55 0.73 0.64

Note: Theoretical research results without transaction costs.
Source: State Street Global Exchange, Worldscope, Thomson Reuters, Datastream.

The strategy materially outperforms the market with less risk. Furthermore, emphasis of the highest-quality stocks, the highest quintiles (Q4 and Q5 above), yielded even stronger risk-adjusted returns. Testing for the influence of other factors on the return outcome confirmed that other influences were not significant, though at times the naturally defensive nature of these high-quality businesses resulted in a less volatile outcome.

Additional Alpha Generation

We also looked at whether there was potential for additional alpha generation via sub selection of a more concentrated portfolio of stocks.

The distribution of annualised return of thousands of randomly sampled portfolios is given below. The potential for additional returns through fundamental research and careful stock selection is evidenced by the significant number of outcomes greater than the mean (bars highlighted in the chart below).

Annualised return distribution

Annualisedreturndistributiongraph

Source: State Street Global Exchange, Worldscope, Thomson Reuters, Datastream.

We also acknowledge the evidence for improved diversification via asset allocation by style factor rather than traditional methods. For example, combining value, quality or momentum exposure across asset classes to achieve diversification – rather than relying on the traditional balanced portfolio combination of equity and debt which was so inadequate in the financial crisis of 2008 (as these traditional asset classes proved significantly more correlated than previously thought).

The potential for additional returns through fundamental research and careful stock selection is evidenced by the significant number of outcomes greater than the mean.

Disciplined, Skilled, Active Management

So, if investing in quality stocks is a winning strategy both for superior returns and as part of broad style-driven diversification, what is the best way to achieve this exposure?

A quantitative smart beta solution could appear to be the simplest, cheapest and most effective. The attractions are obvious:

  • It provides access to proven risk premia, quality, and with an expectation of outperformance of the cap-weighted market.
  • It is easy to access, for example, via a listed exchange traded fund.
  • It potentially comes with lower fees than active management.

What is better than this? A disciplined, skilled, active management approach that delivers this exposure with greater value to the client.

In the diagram below we have assumed the style excess return comes from emphasising quality as a winning investment philosophy. A smart beta solution emphasising the quality factor offers the returns from the first two elements building from the bottom up. Both active and smart beta products offer these returns if following the same investment style. I have called this the passive element, in that the returns come primarily from the design of the product at outset, rather than any active management thereafter.

passiveactivediagram

A Smarter Approach

So why choose an active approach to quality investing in equities?

In our empirical studies and in our client portfolios we have found that significant additional returns can be gained by a sub-selection of stocks from within the quality universe. The adjustment of these stock position sizes through the cycle to take advantage of dips or take profits is another source of value-add over smart beta.

Over and above this, there are other return elements to consider. Style factors are not riskless and can deliver bad outcomes over the short term. Within equities, the returns to the value factor in 1999 or the returns to momentum in 2008 are perhaps the most significant recent examples. Active managers do not blindly rebalance to the style factor with a pre-defined frequency as rules-based strategies do.

This allows active managers to take a smarter approach to managing the extent of exposure to the style factor through the cycle. This can improve returns, lessen tail risk and reduce trading costs. This doesn’t mean we allow style drift. Exposure to quality is maintained throughout, but the extent of that exposure, often informed by valuation discipline, is increased or reduced. Other risk factors can also creep into simple smart beta factor screens from time to time (for instance, momentum risk) and these can be directly managed within active portfolios.

Persistent True Alpha

There is also value from an active approach beyond economic returns.

Active solutions can be tailored to meet the needs of asset owners from ethical restrictions to return and risk objectives. Stewardship of client assets including engagement and voting activity can add value through helping to build the long-term sustainability of investee businesses or in pursuit of particular sustainability goals for clients.

In conversations with clients we find that they are mostly looking for disciplined, consistent exposure to the quality style factor, consistent risk outcomes within their risk appetite, persistent true alpha beyond excess returns that come from the style philosophy and a genuine integrated approach to stewardship. They also want fees that reflect the true value delivered.

All of this can only be achieved with a smart alpha approach to quality investing.

Active solutions can be tailored to meet the needs of asset owners from ethical restrictions to return and risk objectives



Important information

This information is issued and approved by Martin Currie Investment Management Limited (‘MCIM’). It does not constitute investment advice.

Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested.
The opinions contained in this document are those of the named manager(s). They may not necessarily represent the views of other Martin Currie managers, strategies or funds.
The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were or will prove to be profitable.