Enhancing returns without the risk
It is possible to generate equity alpha without taking equity risk according to Dr Raphael Nkomo, chief investment officer at Prescient Investment Management.
He says in the ongoing acrimony between passive and active equity investment styles, there are two facts to consider:
● Passive funds are guaranteed to underperform the market once the passive fund’s fees and the various costs are taken into account; and
● On the other side of the debate active managers have demonstrated their inability to consistently beat passive indices even though they charge large fees with the promise of doing so.
“Each approach has a problem so another avenue is needed — one that takes the middle ground,” Nkomo says.
He says there is enough evidence in the fixed income space that managers, on average, outperform their fixedincome benchmarks over a long period of time and Prescient is known as a strong fixed-income house.
“The challenge is to take this fixed-income strength and leverage it to enhance equity returns. Recently, we have brought a strategy to the market where we seek to enhance equity returns without taking equity risk,” Nkomo says.
Generating alpha in an equity portfolio without taking equity risk can effectively be achieved by using derivatives. By using derivatives a portfolio manager achieves an economic exposure similar to owning the underlying stocks without the need to make a full upfront payment at time of purchase of that equity exposure.
The “cheap” equity exposure allows for independent, complementary strategy able to generate alpha. This is done by using the cash that is freed up by this approach to generate more returns in the enhanced cash and money markets.
“These derivatives can give you the same economic exposure as you would achieve if you used all your fund’s cash to purchase shares, without using all that cash. This places your fund on a parity in terms of exposure to equities and if equities go up you gain and if they go down you lose some value,” Nkomo says.
“When you use derivatives to gain exposure to equities you only fund the margins (initial and variation margins), spending less to gain the same exposure as a full upfront equity purchase.
“As we spend less for our economic exposure, we can leverage off our experience in the interest bearing space to ensure we achieve returns on our enhanced money market investments that are in excess of the cost of the derivatives we use to gain exposure to equities.
“It is not that we are eliminating the risk but rather that we are taking a different type of risk. Fixed income assets are not as volatile as equities and this is particularly true of the shorter term income assets. In most instances we use a maximum of a 13-month duration that is almost like cash.
“Interest rates will continue to move up or down. However, if you are staying in the short end of the curve your assets are not likely to move the same as long duration bonds.”
He stresses that this strategy does not take away all the risk but the risk is minimal. Therefore, applying this strategy in a core plus satellite investment approach, Nkomo says the portfolio’s core should be made up of derivative equity exposure enhanced by fixedincome exposure and the satellite investments can be selected active managers.
Typically actively managed funds will tend to have 75%80% of their assets sitting in an index replica, particularly in a situation where the manager’s mandate is limited by tracking error. Although this ensures manager performance cannot deviate too much from the performance of the benchmark, it also means that the portion of actively managed asset is relatively small. However, asset managers are paid as if they were actively managing the full asset base.
“The starting point is the index and where they are bullish on a stock they increase their weighting in that stock slightly and the reverse when they are bearish on a share.
“However, you pay the manager a fee based on the full amount of the investment, not simply the actively managed portion,” Nkomo says.
“We separate the decision between the passive and active portions and agree managers who can deliver that elusive alpha or outperformance should be well paid. We advocate putting about 70% of the funds into enhanced passive using and 30% into a truly actively managed fund (s) and in this way clients are likely to save significant amount money on the fees they pay.”