Equity strategies that provide systematic exposure to factors such as value, size and momentum are helping redefine “alpha” in a way that will raise the bar for managers commanding active fees, contends a senior executive with MSCI Inc.
Growing interest among asset owners in factor indexes means the traditional view that any returns over a market-cap-weighted benchmark count as “alpha” could give way to a more “granular” definition, predicted Chia Chin-Ping, MSCI Inc.'s Hong Kong-based head of research for the Asia-Pacific region, in a July 25 interview.
“Factor returns are different from alpha,” and increasingly asset owners will find it difficult to justify paying active manager fees for excess returns that come from systematic exposure to those risk premiums, said Mr. Chia.
That should leave only “true skill, either in picking a stock, or timing the market or through better asset allocation” as the basis for charging active fees, he added.
Under that “cleaner definition,” an ability to deliver alpha across the various phases of an investment cycle will become a more important measure of manager skill than merely delivering alpha over the course of a cycle, he said.
In MSCI's June 30 announcement regarding research it conducted for Japan's ¥127 trillion (US$1.25 trillion) Government Pension Investment Fund on how passive factor strategies should be used in tandem with traditional passive and active mandates, Mr. Chia said that different governance demands for each made it advisable to position factor indexes as a distinct “third bucket.”
MSCI's GPIF research found different factors — value, size, low volatility, high yield, quality and momentum — offering annualized long-term risk premiums over the firm's market-cap-weighted benchmarks for Japan, developed markets ex-Japan and emerging markets of between 30 and 260 basis points for the period from the end of November 1995 through the end of August 2013, said Mr. Chia.
But factors are cyclical, so having a strategic belief that exposure to factors can yield those long-term risk premiums over, say, a 10-year period is “very, very critical.” Seeing that exposure as a cost-effective alternative to active management will lead investment committees “down the wrong path” if they ask “is this factor portfolio generating enough alpha for me,” noted Mr. Chia.
“As people start to appreciate the role of factors in their portfolios, what it provides them is a view to take systematic risk exposures, (which) are technically not alpha. If you still want to pursue traditional seeking of alpha, then you should define alpha cleanly, (as returns) above and beyond what certain systematic exposures provide,” said Mr. Chia. “That's what I think anyone would be willing to pay for,” he added.
Mr. Chia declined to go into detail regarding MSCI's talks with GPIF on how allocations to different factors should be combined. He said MSCI will be releasing a research paper regarding different approaches to combining factor investments over the next month or two.
In April, the GPIF announced a reorganization of its domestic equity portfolio in line with MSCI's “third bucket” approach — adding, alongside its traditional active and passive categories, a “smart beta active management” category to “effectively capture mid- to long-term excess returns” through indexing strategies.