Dan Miles

Analysis conducted by Innova Asset Management of more than 100 Australian equity managers reveals that the two strongest factors driving share return variability in Australia are momentum and valuation and most active managers are not generating extra returns for their investors through management skill.

Innovas’s analysis reveals that the performance of even the best active managers doesn’t persist over time^[1] and many fund managers are only delivering ‘naïve alpha’. Naïve alpha is alpha derived from being invested in a particular style or exploiting a particular factor over time, meaning that is the style or factor they are exposed to that generates the ‘alpha’ not manager skill (true alpha).

“Our research has found evidence that factors explain around 90 per cent of fund managers’ return variability and the way that their performance wanes over time,” said Dan Miles, Innova Managing Director and Co-Chief Investment Officer and co-author of the whitepaper, Factors, Funds and Performance Chasing^[2].

All investors focus on some type of fundamental characteristics when investing, such as ‘value’ or ‘growth’. There is increasing evidence to suggest that these factors are the key driver of the outperformance of equity managers, or ‘alpha’.

“Innova’s analysis of more than 100 Australian equity managers shows the impact of two of the strongest factors – momentum and valuation – on performance. It also helps 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. 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.,” said Mr Miles.

“This should prompt investors to think of better 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,” Mr Miles said.Innova’s whitepaper discusses the role of investment styles and factors in driving manager performance and how understanding these factors can lead to a better evaluation of a manager’s true performance. Different factors drive equity returns depending on financial or economic fundamentals. Value stocks have low prices relative to their financial fundamentals such as earnings. Momentum is a well-known factor that refers to investing in companies with strong price trends. Being sentiment-based, strong past returns are associated with strong future returns (but only in the short term). Quality involves investing in companies with healthy balance sheets including strong earnings and low debt, while size refers to small or large companies.

The diagram below shows the impact of one-year past performance (higher past performance suggests strong momentum) and five-year past performance (higher past performance suggests the valuation is becoming more expensive) on fund manager performance.

“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 5 years, their particular style of investing has likely become expensive (has a high valuation) and is likely to perform poorly as future returns have been priced into the style they are following.”

Innova believes there is merit for investors to rotate in and out of different styles using these two and other factors 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. This approach is one of Innova’s key competitive advantages, and we continue to research and refine our approach to delivering factor-adjusted alpha rather than naïve alpha,” said Mr Miles.

“This can help equity investors, as well as those investing in other asset classes, extract the most outperformance from their strategy.”

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Notes:
[1] ASIC Report 22: A review of the research on the past performance of managed funds. September 2002 – (revised June 2003). Retrieved from https://download.asic.gov.au/media/1337666/FMRC_Report.pdf.
[2] https://innovaam.com.au/news-and-insights/

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