Asset owners blend styles, factors and managers in their quest for diversified portfolios and diversified sources of return, but it can be difficult to determine and monitor those exposures, and fund managers must be clear about their culture to avoid style drift.
Merlon Capital Partners chief executive and portfolio manager Neil Margolis, and Invesco quantitative strategies senior portfolio manager Andre Roberts, engaged in an almost metaphysical discussion of style, process and product as part of the Investment Magazine Equities Summit in Melbourne.
To begin with, to determine if a manager’s process and product are being true to label, managers and asset owners must be clear on how to define the characteristics that make up the style, Roberts said.
“One of the things that struck me is that most of the investment processes and products out there, they talk about style in terms of the stocks that they like to buy, or in terms of the characteristics of companies,” Roberts said. “[They say,] ‘We like earnings growth, we like quality management teams, stocks that have value or are mispriced according to measure of intrinsic value.’
“I started thinking, a characteristic is really a factor, and factor investing is using characteristics in your investment process, so I’ll put it to you that if everyone is talking about characteristics when they’re describing their process, everyone is a factor investor. It’s just that there are a whole bunch of different shapes and sizes.”
This makes measuring style drift tricky, because it depends on what’s used to define the style in the first place, he said. Roberts demonstrated, using a series of products across style matrices, that when measured on rolling regressions over a given number of years, there are considerable variations within each product, because a portfolio is “a combination of assets at a point in time, where the assets are a range of ideas at various points of maturity of the idea”.
“If it was a new idea in the portfolio and you were a value manager, you’d hope to have a deeper value position in your fund, but if it’s a mature idea and the thesis has come true, it would be less value-y,” he said. “A portfolio snapshot is going to have a range of exposures. Over time, the portfolio exposure to value is going to vary.”
In contrast, Margolis said “value, defined as free cash flow, does actually work and has worked in the past decade or two when the rest of value struggled”,
“It’s nothing to do with excess risk taking – it actually does better in down markets,” he said. “The reason I think value investing defined this way can continue to outperform is because of behavioural biases that exist in the market, both at the manager level and the institutional asset owner level.”
Margolis posited that if one uses a measure of value defined as free cash flow, then any alpha generated is not due to excess risk taking, rather it’s because of behavioural factors in other investors.
To maintain style consistency, Margolis said, it is necessary to define a process for how a fund manager values stocks with a long-term view, and establish a culture to combat behavioural bias.