Finding alpha with few bets

Some institutional investors are betting on highly concentrated equity portfolios to gain more alpha while at the same time expanding allocations to their core passive strategies, according to consultants, managers and pension fund executives.

As global equity markets are showing signs of a lengthy slowdown and investors are more cautious about costs, a new approach to the traditional core-satellite strategy is spreading across the world. The idea is anchored on the premise that investors in active equity strategies that hug a particular benchmark might be paying for alpha but getting mostly “closet” beta, consultants and managers said.

Another contributing factor is the poor performance of enhanced indexing and quantitative risk-control strategies. Once considered as a reliable way of harvesting alpha, many of these strategies — which tend to make a large number of small bets against an index — have nosedived in performance, driving investors to seek different sources of return, consultants said.

According to proponents of the updated core-satellite approach, investors should use a largely passive core portfolio coupled with more concentrated bets to maximize alpha in a cost-efficient way by using one or more concentrated managers.

“It's core-satellite on steroids,” said Francis M. Kinniry Jr., principal in the investment counseling and research division at the Vanguard Group, Malvern, Pa.

As much as 75% of an equity portfolio could be passively managed in such an investment approach. The remainder is actively managed and usually comprises concentrated portfolios containing as few as 15 to 20 stocks.

While the number of funds and assets under management linked to such strategies is unknown, consultants in Europe and the U.S. are seeing evidence the approach is attracting more pension funds, endowments and asset managers.

“Some funds are moving in this direction, but there are practical challenges related to risk tolerance at the individual manager level, which have kept other funds from attempting this,” said Rich Nuzum, president and global head of investment management business at Mercer LLC in New York.

Roger Gray, chief investment officer of London-based Hermes Pensions Management Ltd., which manages £37.3 billion ($72.9 billion) British Telecom Pension Scheme, said the fund has been gradually moving more developed market large-cap equity assets into passive management in what is both a fee-optimization exercise and risk budget reallocation for that category. The fund's total equity portfolio, which amounts to about £20 billion, is now 70% passively managed.

The shift allows the fund to focus more of its risk budget on enhancing returns from less efficient markets and higher alpha strategies.

For example, Hermes' active small and midcap, and emerging market equity portfolios are now more concentrated with a tracking error as high as 7.5%.

“We're working out where we should be taking active risks, and where we are likely to find the best chances of obtaining outperformance,” Mr. Gray said.

The Lothian Pension Fund, Edinburgh, Scotland, employs a similar structure in its U.K. equity portfolio. About two-thirds of the £540 million portfolio is passively managed internally while the remainder is externally managed using a concentrated strategy that invests in about 35 to 40 stocks.

In 2009, when fund officials embark on an asset allocation review, they might consider extending the approach to other equity strategies, said Geik Drever, head of investment and pensions at the £3 billion fund.

“We're looking to move more (active equity) assets to a passive approach and managing it in-house,” Ms. Drever said. “That allows us to spend more of the risk budget in getting more alpha from our active managers.”

In the U.S., similar core-satellite strategies are being implemented, mostly within the domestic equity portfolio, said James R. Neill, managing director in Wilshire Associates Inc.'s consulting division based in Pittsburgh. Mr. Neill said at least a third of the clients he's advising, including officials at endowments and corporate defined benefit plans, are increasing passive equity to at least 60% from about 50%.

Not only are investors implementing concentrated portfolios as a result, some are further compressing the number of stocks held in those strategies.

“It's not uncommon to see shifts in concentrated portfolios that previously had 60-plus names to those with 20 to 40 names in the portfolios,” Mr. Neill said. “It's a good bit more concentrated. There's greater potential for return but also greater deviation from the benchmark.”

Critics, including Vanguard's Mr. Kinniry, said investors might not have the tolerance needed to implement highly concentrated equity strategies because such portfolios are significantly more volatile.

Mercer's Mr. Nuzum said: “You may be moving to a situation in which your active managers may be underperforming by about four (percentage points) in a bad year to a situation where they may be underperforming by 8 to 12 percentage points.

“If the board's reflex is to want to fire those managers and hire other managers that have a good recent track record, you'll end up with an undiversified manager structure and, at some point, the whole program is going to massively underperform.”

Equity managers said most investors understand the risks and increasingly see potential in highly concentrated portfolios. Olivier Lebleu, managing director of MFS Investment Management, London, said the firm is a finalist in three U.K. searches involving a total of more than £1 billion in assets for its newly launched global concentrated equity strategy. MFS is also short-listed in tenders from two Australasia funds.

The portfolio holds a maximum of 35 companies with higher alpha-generating potential. Since inception in January 2007, the fund has outperformed the Morgan Stanley Capital International World Index by 5.1 percentage points, net of fees.

“We think this kind of product has much more potential to reach the kind of performance targets that investors want in the current (market) environment,” he said.

Christian Dargnat, chief investment officer of BNP Paribas Investment Partners, Paris, said his firm has been thinking along the same lines in three European equity mutual funds, each with more than €1 billion ($1.5 billion).

In mid-2007, BNP decided to switch these funds from an enhanced index strategy to one in which three-quarters of the portfolio passively follows an index and the remainder is a highly concentrated portfolio of about 20 stocks. The approach helped to turn performance around for the manager over the past year in the midst of difficult market conditions.

Contact Thao Hua at [email protected]