Overdiversification and the Quest for Alpha -- What Every Equity Investor Needs to Know: Podcast
Podcast Epdisode 004: Transcript
Celina. Welcome to “Human Led, Research Tested”, the Active Quantitative Equity podcast – a series of in-depth conversations with experts from State Street Global Advisors. Our goal in this podcast is to bring investment processes to life. I'm Celina Rogers and I'm here with Kishore Karunakaran and Rob Shapiro to talk about their recent research, which showed how overdiversifying active managers can hurt equity investors in their quest to reach their investment objectives, and what those investors can do about it. Welcome Kishore.
Kishore. Hi Celina.
Celina. And hello Rob.
Celina. I think what we want to talk about today are some of the limits of diversification, and how investors can and should consider diversification more broadly when they look at their investments at the portfolio level. Going back to the beginning, Rob, and your initial research into the topic, what did you observe about the portfolios that that you were reviewing and how did you how did you start to gain this spark of insight into a potential research topic?
Rob. So the initial goal of the analysis was to see what factors clients were exposed to. And over time we noticed that another important conclusion was that most of these larger funds had a low active risk. This is a problem because they did not have a great potential for a large outperformance.
Celina. So you start with the benchmark with no active risk, and as you start to measure deviation from that benchmark, that is attributable to the active decision making and represents active risk.
Kishore. Active returns are the returns achieved by an active manager by deviating away from some policy benchmark. Active risk is the active manager taking deviations, again from the benchmark, measured by volatility of the deviations.
Celina. So even among sophisticated investors, active risk can come across as a negative or has a negative connotation. But your research suggested that, in fact, it's really not possible to achieve some of these return goals without taking a certain amount of risk. You really can't divorce the two, as a practical matter.
Rob. Right. It's very difficult to achieve a certain return without taking some active risk. If you take no active risk you have a zero active return. And if you have a small active risk, it's also very difficult to get a large active return.
Celina. I think, in your research, the phrase that sticks in my head is “order of magnitude increase in forecast accuracy.” Can you unpack some of those findings?
Rob. In order to achieve a certain return, there’s a relationship between active risk and the accuracy of forecasting. We found that that the accuracy needs to increase exponentially to account for the reduction in tracking error.
Celina. You recently authored a research report that focused on overdiversification in the active equity sleeve of investors’ portfolios. What led you to investigate this question?
Rob. We were analyzing a lot of different clients’ portfolios from a total portfolio level and we were looking to see how they were exposing different factors in different countries, different sectors. And we noticed that many of them had very low active risk.
Celina. These are large institutional investors for the most part?
Celina. When you noticed that they were exposed to relatively low levels of active risk – what might be the consequences of that?
Rob. We felt they would not be able to achieve the returns that they're trying to achieve.
Celina. You were encountering people even in this population of sophisticated investors who actually felt, “Our active risk is low, why wouldn't that be a good thing?”
Rob. At an individual portfolio level it is sometimes seen with a negative connotation when there’s a very low active risk and funds are charging active fees. So we took that and we extended a little further, and really it’s more important how the overall portfolio is positioned, not just this one account within a portfolio.
Celina. So this this phenomenon takes shape as investors look from individual fund or manager to manager and say, “Well, here's my active risk exposure and here's my potential for a return that's associated with that. And here the fees that I'm paying, all of that looks fine move on to the next manager do the same analysis. All of that looks fine.” And I think your point is if you look at the total exposure in the active sleeve of the portfolio, that's where you can run into a problem.
Rob. It does seem like clients do concern themselves with paying high fees for very low active risk at the account level; however, we've noticed that a lot of clients are not that concerned – when they should be concerned about this – but don't seem to be concerned about paying higher fees when their overall portfolio has low active risk.
Kishore. Rob’s paper with Ric Thomas and Shawn McKay shows that large plans with 50 billion [dollars] or more are forced to allocate to several managers because it’s virtually impossible that one manager would get five billion dollars out of that 50. So they're forced to invest in a number of managers, and then this forces the overall risk level to essentially come down dramatically. So even though these individual managers might have tracking errors of potentially 5 to 10%, maybe even 8%, as you combine 20 or so managers, you start to get these undesirable risk outcomes, where the tracking error drops precipitously to levels of one and a half [percent], which is really the risk level of an enhanced fund. And now you have to justify paying these very hefty fees.
Celina. One of the things that leads to this phenomenon is this sort of blinkered view of looking manager by manager at the active risk exposure and the fees that are being paid. And I think that's where in your research with Ric Thomas and Shawn McKay, Rob -- the fees per active risk ratio and also fees per active share ratio help to really illuminate some of these issues and gave investors a simple way to estimate the active exposure they were paying for.
Rob. So we looked at a lot of different accounts within the universe and they generally had standard, active fees, and then we noticed when we combine the managers, on average they would obviously keep very similar fees, but the active risk when you combine managers would drop down dramatically. For example, one client might have 10 managers and another client might have two managers, and for the same fees, the one with two managers would generally have a higher active risk, which will cause them to have a lower fee per unit of active risk.
Celina. So it makes a pretty profound impact. And just circling back to what Kishore was saying, there are reasons why this dynamic takes shape, and one of them is – particularly among very large investors – is capacity constraints in active funds. So that led you and Kishore to join forces to explore some of the possible solutions that investors could think about when it came to solving the problem of overdiversification in active.
Rob. Yeah, a lot of these large institutions are forced to hire a lot of managers due to capacity concerns. But a fund like an enhanced fund has a much higher capacity, so investors are able to invest in less enhanced managers than they would to a [traditional] active manager. And even though enhanced funds have lower active risk, when you combine two or three enhanced funds, because of capacity, a large institution could invest in two or three enhanced funds – that portfolio would actually have a higher active risk than an account being forced to buy 50 concentrated active managers.
Kishore. Yes, so we can take a simple example. So Rob and I looked at various combinations of active managers and enhanced managers, and we found that, for instance, an enhanced manager with an active risk of one and a half [percent] and an active manager with a risk of 5 [percent], when you combined 25 active risk managers and only 2 enhanced managers, you end up with an active risk of roughly about the same: 1% for both groups. However, the FAR ratio, the fees per active risk, is point .5 in the case of the active group highly active group and point .15 in the case of the enhanced active group.
Celina. So when we say an “enhanced” fund here, we mean…
Kishore. An enhanced fund in our world is just a tightly-constrained, highly risk-controlled fund using the entire stock selection apparatus that the active quantitative equities team uses. And so typically it’s another form of active management, but with a lot more risk controls.
Celina. Rob, Ric and Shawn did this research on overdiversification in the active allocation. And then you teamed up with Kishore to explore potential solutions. What drew you to enhanced funds in that case?
Kishore. Enhanced active is a solution to over diversification. It’s a fully integrated framework for managing your expected returns and controlling, or keeping in very tight bounds, your risk controls.
Celina. So as a practical matter for investors, investors who are willing to take on active risk -- to pay an active management fee to take on active risk in order to gain the potential for that degree of outperformance – what does this research mean? What's the takeaway for them? What kind of doors and thinking should this open for them?
Rob. For smaller institutions, ones are under maybe five billion, they still can hire a smaller amount of active managers and still achieve their goals. Then are the capacity constraints are not as constraining on them. But for a larger institution the capacity constraints may force them to allocate a lot more to an enhanced-type fund.
Kishore. We have other variations of active management such as our benchmark unaware strategies, where you’re now taking risk but that risk is measured the risk is not measured in benchmark-relative risk terms, but total risk. So these strategies seek to deliver high expected returns but low total risk. In other words with capital preservation in mind, not benchmark relative risk – because as you take benchmark-relative risk you lose some flexibility to provide downside protection. So these strategies have also done quite well and have been around for about 10 years.
Celina. And so from your point of view Kishore you know the work that you've done together that kind of thinking that you've done and the kind of thinking that this represents here at State Street, do you think that's a competitive advantage for us here?
Kishore. Yes, it is definitely a competitive advantage. Well active quantitative equities has had over three decades of investing acumen using systematic methods, but our enhanced strategies have track records of over 18 years, delivering return targets that have exceeded their benchmarks.
Celina. It was an incredible conversation. Thank you so much for being here Rob.
Rob. Thank you.
Celina. And Kishore.
Kishore. Thank you.
Celina. If you want to hear more about overdiversification and about active quantitative equity, please visit us at SSGA.com