Which active equity strategies can deliver value for pension scheme investors? Cambridge Associates’ Himanshu Chaturvedi gives his views.
Action points
Now that interest rates are rising, consider value equities
Pick managers with skin in the game (it is an excellent motivator)
Think long term, as even the best will lose form periodically
This means sifting through unfashionable investments – and in the current economic climate, one of these is value investing.
It is 10 years since value equities led the market. Ever since 2006, they have ceded ground as falling interest rates have tended to favour stocks seen as bond proxies – namely, those with low volatility and high quality characteristics.
Beyond deep analysis of the investment process, investors should pay particular attention to the alignment of interest between investors and fund managers. Having skin in the game is a wonderful motivator
Now, with interest rates rising, value equities could be poised to rebound as expensive bond proxies suffer a performance drag. As it stands, the relative valuation of value equities versus the median stock is at a 35 per cent discount – near historical highs.
But spotting the opportunity is one thing, seizing it quite another. Pension funds must get the implementation right.
Factor investing
One popular option is factor investing, where investors rely on systematic factors thought to be rewarded with extra return. But investors should be wary.
These are widely marketed as ‘cheap, passive’ products. However, factor investing is a decidedly active strategy because different interpretations of the same factor can lead to wildly different results.
For example, we have seen performance differences ranging from 4 per cent to 7 per cent a year over 10-year periods between products that claimed to capture the value factor. So it pays to conduct deep due diligence, as with any active fund managers.
Fundamental investing
Another option is classic fundamental active equity investing. Of course, recent poor performance has eroded trust in this approach. But the massive growth in passive investing has the potential to create the kind of valuation distortions that active managers can exploit to generate alpha, especially for opportunistic strategies unconstrained by benchmarks.
Again, picking the right managers is key. Beyond deep analysis of the investment process, investors should pay particular attention to the alignment of interest between investors and fund managers. Do they limit their assets under management? Do they offer fee structures that only reward sustained outperformance? Do they have a focused approach that resists product proliferation? Ultimately, do they invest significant amounts of their own assets in the fund? Having skin in the game is a wonderful motivator.
Long/short
In pursuit of alpha, investors can venture further along the spectrum of opportunistic strategies in a couple of ways. One is long/short equity investing. The best long/short managers are able to beat the market over the cycle despite running lower risk.
Admittedly, recent times have seen many former star managers’ track records take a beating. But this does not necessarily invalidate the long/short approach.
Private equity
At the most opportunistic end of the spectrum lies private equity, where we have consistently found excess return. Again, this suits pension funds, since the long-term nature of private capital opens up opportunities that are not available in public equities, such as corporate turnarounds, growth capital for younger companies, and businesses with longer capital cycles where talented executives can truly add and compound value.
Nilgosc turns to low vol equities
The Northern Ireland Local Government Officers’ Superannuation Committee has made a £300m allocation to low volatility global equities in an effort to reduce overall risk while closing its funding gap.
In our experience, pension funds have been consistently able to earn 300-500 basis points more return per year through private equity than equivalent public investments.
As always, the challenge is repeatedly selecting the best managers over a long period. The difference between the top and bottom quartile of managers is 12 per cent to 18 per cent a year in private equity and venture capital.
So, to find the best opportunities, investors should be prepared to take the long view in equity investing – not only when allocating capital, but also when selecting managers.
Even the best managers go through torrid times: for example, in the 10-year period ending September 30 2016, 48 per cent of the top quartile of US mid/large cap equity managers endured at least one three-year period in the bottom quartile. Fortunately, pension funds have the advantage of time.
Himanshu Chaturvedi is senior investment director at Cambridge Associates
