Innova Asset Management’s recent analysis revealed that the success of numerous active managers can be ascribed to “naive alpha”, stemming from their strategic investment in a specific style that exploits a particular factor consistently over time.
It is “naive alpha”, according to the firm, that is generating extra returns for investors as opposed to the skill of the fund manager, or “true alpha”.
In a survey of over 100 Australian equity managers, momentum and valuation emerged as the key drivers of share return variability. Notably, the study found that even the top-performing active managers struggle to maintain consistent performance over time.
Dan Miles, Innova managing director and co-chief investment officer, said that these findings explain why most active managers don’t deliver consistent alpha over the long term.
“Over the short term (12 months), managers who have a style or factor bias, have positive momentum behind them and therefore tend to do well the following year,” Mr Miles noted.
“However, if they have performed very well over five years, the valuation of that exposure has become expensive, and we see performance mean-revert back down again.”
The research also showed that investors universally prioritise fundamental characteristics like “value” or “growth” when making investment decisions, with evidence mounting that these factors actually play a pivotal role in driving the outperformance of equity managers, often referred to as “alpha”.
Mr Miles said this should prompt investors to reassess options that can deliver higher returns.
“A better understanding of these two factors and others such as company size, quality, and volatility can identify fund managers delivering naïve alpha and help investors avoid paying excess fees for a style bias that that they can access at a lower price through style or factor-based systematic strategies such as ‘smart beta’ offerings,” he explained.
Looking at the impact of past performance, Innova found that fund managers who performed well over the past 12 months are likely to perform well over the next year. However, those that have a high performance record over the past five years likely have more expensive valuation.
“Most fund managers’ performance over time shows that if they’ve performed well over the past 12 months, they’re likely to over the next 12 months. However, if they’ve performed well for five years, their particular style of investing has likely become expensive and is likely to perform poorly as future returns have been priced into the style they are following,” said Mr Miles.
As such, he suggested there is value for investors to rotate in and out of different styles as market conditions change to suit them.
“Factors that have performed well over the last few years will still likely cycle back to underperforming over the medium term. The challenge is to understand why and then implement this factor rotation in a systematic, rules-based fashion,” he said.
“This can help equity investors (as well as those investing in other asset classes) extract the most outperformance from their strategy.”
