Alpha versus beta

Should investors spend time choosing the best manager, or diversifying?

Active managers are having their worst year relative to their benchmarks since 1998. And as I’ve noted in previous articles, The true cost of beta and Alpha’s residual nature beta is much cheaper than alpha.

These days investors can access to TSX return for as little as 0.07%. In contrast, most hedge funds charge 2% of capital and a 20% performance fee. The average active Canadian large-cap fund MER is about 1.50%, excluding advisor compensation.

Yet study after study shows the majority of mutual funds simply generate beta. Why should the investor pay 150 bps for beta when he can get it for 7 bps?

Another difference: alpha is a residual value from a pertinent benchmark. It’s what is left after all sources of beta have been accounted for.

Alpha and beta also have different impacts on portfolio performance and volatility. When building a portfolio, selecting among active managers adds little value both in terms of performance and volatility reduction. On the other hand, diversifying across various asset classes and risk-premium exposures has considerable impact.

Let’s start with a TSX-benchmarked portfolio.We are looking for either a potential for increased return or a potential for increased diversification; preferably both. So is it easier to gain potentially higher return and/or diversification (through greater return dispersion between the portfolio’s constituent parts) by manager selection within an asset class—alpha, or by selecting between various asset classes—beta?

Betting on alpha

On the mutual fund side, Standard and Poor’s Indices versus Active (SPIVA) 2010 report tells us 19.64% of Canadian large cap managers beat the TSX over a 12-month period, 10.94% over a three-year period, and 2.53% over the five-year period. For the five-year period, the average mutual fund return is 3.88%, versus 6.51% for the TSX.

Being less expensive than their Canadian counterparts, funds in the U.S. have fared better. Over the one-, three- and five-year periods, 34.28%, 42.35% and 38.17%of actively managed funds outperformed the S&P 500. For the five-year period, the median fund performance is 1.89%, versus 2.29% for the S&P 500.

As we can see, mutual funds in both Canada and the U.S. basically track their benchmark, minus fees. So we look to the institutional side, where fees aren’t so egregious and where alpha generation efforts can be taken more seriously. (Institutional managers post returns gross of management fees, so they are taken out of the equation.)

Let’s look at the five-year performance of large-cap managers on the Mercer Pooled Fund Survey. As of December 2010, the median large-cap pooled fund five year performance was 6.54%, just 0.03% higher than the TSX.

For the years 2009, 2008 and 2007, respectively, the median pooled fund Canadian large-cap mandate had gross five-year returns of 7.95%, 5.02% and 18.8%, versus TSX returns of 7.66%, 4.16% and 18.3%. The average alpha for those four five-year rolling periods is a slim 0.42% before management fees. If you happen to have $10 million invested, the average management fee is 45 bps (not counting custodial fees), so any added value is gone.

How did best-of-class managers fare? For the four five-year periods, top-quartile mandates beat the TSX by an average of 1.16% before fees. If you had $10 million to invest and managed to pick all top-quartile managers, you would have outperformed the TSX by 70 bps, before custodial fees.

The TSX has a historical standard deviation of 15%.To encompass 95% of all probable returns for any given year, we need to consider two standard deviations. This translates in a probable range of 30% above or below the TSX’s average annual return. Assume the historical return for the TSX is 10%, resulting in a possible return of anywhere between +40% and -20%, or a 60% range.Would you notice a 0.70% difference? It’s on the same scale as a krill hitting the backside of a whale.

Betting on diversification

Another indication that mutual funds just track their indices is how little dispersion there is between the various performance quartiles. Although not available in the Canadian SPIVA study, the U.S. study tracks the performance of the first, second and third-quartile funds in addition to the median.

For 2010, 2009 and 2008, the differences in performance between the first and third quartile for large-cap core mutual funds in the U.S. were 3.55%, 8.63% and 5.98%—for an average of barely 6%. For the three-year period ending in December 2010, 2.85% separated the first and third quartile. For pooled funds, the results are similar. For the same three years, the difference between first and third quartile is, on average, 5.79%.

The chart below shows 12 different asset classes, including the TSX. A to D are various fixed income asset classes such as government bonds, real-return bonds, corporate bonds and so on. The other eight asset classes are non-fixed income asset classes ranging from equities to real estate to broad commodities.

Each year, asset classes are ranked from top to worst performer.The colours bounce around each year as each asset class’s performance rank varies. To maximize diversification, we should have a wide dispersion between the different rectangles each year, and always have some positive and some negative rectangles. Otherwise, all the asset classes would be moving in unison and the portfolio holding them would swing wildly.

Return dispersion between the different asset classes in any given year is much greater than the dispersion between the SPIVA and Mercer managers discussed above. The difference in returns between the top- and bottom-performing asset class varies between a low of 12.79% to a high of 57.35%, and has an average of 41.91%. This means the potential for diversification is much more substantial for beta than for alpha.

Also, in any given year, there is at least one asset class that outperforms the TSX, sometimes by as much as 42%. If you diversify the portfolio, there’s no need to guess which asset class it will be each year, as it is also impossible to guess which managers will end up in the first quartile each year. Yet forgoing those asset classes in any given year means forgoing extra return.

The 10-year period is especially favourable to the TSX. It has a compound annual growth rate (CAGR) of 5.6%versus 1.6% for EAFE stocks and -3.9% for the S&P 500. Their respective standard deviations range from 15.44% to 17.78%.

We can put beta diversification to the test by building an equal-weighted portfolio and simply rebalancing it quarterly. To make things more challenging, we can exclude any fixed-income beta, so as to have a truer comparison to being invested only in the TSX. That gives us a portfolio with eight equally weighted asset classes.

Each quarter, the portfolio is rebalanced.There is no active management or tactical call behind the individual asset classes, as they are represented by their indexes and their respective weights remain 12.50%.

That portfolio would have had a return standard deviation of 12.37%. Diversification has resulted in a portfolio that is less volatile than the individual indexes. What may be more surprising, especially given that the period we’re looking at is quite favourable to the TSX, is the equal-weighted portfolio’s CAGR comes in at 7.2%, versus 5.6% for the TSX.

In short, diversifying across beta exposures (without fixed-income) and rebalancing could have given the investor an extra return of 1.90% over the best of the three main indexes over the 10-year period.

Doing so would have also lowered risk (the standard deviation is lowered to 12.37% vs 15.44% for the TSX). In contrast, the median managers we looked at earlier had a performance of 0.42% above the TSX (we have no information on the standard deviation) over the five-year period studied.

Guy LaLonde is an investment advisor and portfolio manager at National Bank Financial and is based in Pointe Claire, Quebec.