Understand. Act.
Active Management
Content
4
How to react?
Imprint
Allianz Global Investors
Europe GmbH
Bockenheimer Landstr. 42 44
60323 Frankfurt am Main
Global Capital Markets & Thematic Research
Hans-Jrg Naumer (hjn)
Stefan Scheurer (st)
Dora Janikovszky
Active Management
Figure 1: Active Equity Managers Have Generated Substantial Value for Clients over the
Long Run (Mercer Database)
Relative performance of global equity managers according to Mercers GIMD database
Performance MSCI World in USD (indexed)
Relative performance
vs. MSCI World in USD
500
40 %
400
1.6 %
p. a. relative
300
30 %
20 %
200
10 %
100
0%
10 %
Dec-93
Dec-96
Dec-99
Dec-02
Dec-05
Dec-08
Dec-11
2
Return per Risk Lever
Expand Investment Universe
High
Risk Lever
Increase Risk Taking
Low
High
All-Cap
MultiSector
Low
Country
Allocation
Market
Timing
SingleCap/
Sector
Local
Liquidity Profile
Global
Macro
Economic
Exposures
Geographic
Sector
Allocation
Investment
Styles
Short Term
Trading
Strategies
Active Return
Trading
Costs
Fundamental
Company Research
Information
Gain
130 / 30
Long-only
Constraint
Tracking Error
Two ways to react to lower returns per risk: Increase risk, or increase return per risk.
Source: CaseyQuik (2013); Allianz Global Investors
Active Management
To make things more complicated, correlations after 2003 are significantly higher than
correlations before 2003. A possible explanation for todays greater correlations may be
found in the increase of institutionalisation
of the asset management business i. e., the
use of commonly accepted sector definitions,
common risk models, common cap-weighted
benchmarks, and, in particular, the rise of
indexing. This homogenisation of investor
practice has led to a loss of diversity in stock
behaviour and hence to an increase in correlations.
As a result, although the relatively high level
of correlations may not only be a cyclical
phenomenon, correlations can be secularly
higher due to the rise of institutionalisation.
How to react?
If past levels of portfolio activity and portfolio
risk deliver only compressed alphas instead
of the ample alphas of the past, we see two
principal ways to deal with this challenge:
Increase the level of risk
Increase the return per unit of risk
The following chapters will provide a detailed
discussion of these two levers for enhancing
the proceeds from active management and
derive applicable practical implications for
day-to-day portfolio management.
Relative Performance
Relative Performance
3.0
2.0
1.0
0.0
2.0
1.0
0.0
Low
2
3
4
Quintiles of active share
high
Low
2
3
4
high
Quintiles of tracking error
Source: Cremers & Petajisto [2013], Data from 1/1990 12/2009, Allianz Global Investors
Past performance is not a reliable indicator of future results.
6
High
High
1.9 %
1.7 %
3.3 %
3.0 %
3.6 %
2.2 %
2.0 %
1.6 %
0.6 %
1.1 %
2.0 %
1.4 %
0.9 %
1.1 %
0.0 %
0.6 %
0.8 %
0.5 %
0.3 %
1.3 %
Low
0.1 %
0.4 %
0.4 %
0.2 %
0.8 %
Source: Cremers & Petajisto [2009], Data from 19902003, Allianz Global Investors
Past performance is not a reliable indicator of future results.
Active Management
Analysis is based on
monthly observations of
360 U.K. pension funds
from 1986 to 1994 provided by the WM company.
First, there are the concentrated stock pickers. Their portfolios are characterised by a
very high level of active share that reflects
their high level of stock picking activity.
Their portfolios are also characterised by a
higher tracking error that reflects their more
concentrated approach to stock selection
because high-active-share, high-trackingerror portfolios are concentrated stock picking
portfolios that target high alphas either in a
benchmark-relative core equity setting or in a
benchmark-agnostic unconstrained setting.
1980
1985
1990
1995
2000
2005
2010
As such, many investors that consider themselves stock pickers are not stock pickers in
the narrow sense of factor risks models, but
are stock pickers as defined by Cremers &
Petajisto. The latter definition of a stock picker
clearly matches much better what investors
intuitively classify as a stock picker. In addition, this definition has a strong empirical
backing as a successful investment approach.
We therefore believe that this is the more
appropriate concept of stock picking.
Active Management
Understand
IR IC BR TC
Breadth
where
IC: Information Coefficient, measures the quality of the return predictions
BR: Breadth, the number of independent predictions
TC: Transfer Coefficient, measures how accurate forecast are translated into portfolio weights
10
Transfer Coefficient
1,000
2,000
800
1,500
600
1,000
400
500
200
0
0
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Portfolio risk has traditionally been determined by relative volatility and potential
deviation from a benchmark. As portfolios
become more concentrated and more differentiated from the benchmark, this exercise
becomes less useful. We look instead at
permanent loss of capital from operational,
financial or valuation risk. This heightened
awareness of absolute risk consequently leads
to a more intensive analysis of the intrinsic
quality of a business.
11
Active Management
But improving the quality of return predictions does not mean dealing only with the
level of IC. Improving the stability of ICs is as
important as enhancing the level of ICs. As the
research by Ding [2010] shows for broadly
diversified portfolios, reducing the volatility of
ICs by 50 % has the same effect on the information ratio of a portfolio as doubling the
level of ICs.12 Increasing the stability over time
is very much interlinked with increasing the
breadth of strategies that return predictions
are based on.
2. Breadth of strategies
Secondly, a larger breadth in implementation is rewarded. In the context of the fundamental law of active management, breadth
refers to the number of independent bets in
a portfolio per year. It is not just the number
of active positions in a portfolio, but also the
independence of bets that is crucial.
The breadth can be increased in a number
of ways that are interrelated, such as:
Increasing the breadth of investment
strategies
Increasing the diversity of single stock
positions
Increasing the breadth of investment
strategies
It is beneficial to the risk-adjusted performance of an investment product if the
manager adds additional sources of alpha to
the process, even if those sources are small
in comparison to the major source of alpha
of the fund. Multi-strategy funds beat singlestrategy funds, as academic studies like Huij
and Derwall [2009] show.13
We at Allianz Global Investors firmly believe in
the superiority of multi-strategy approaches
over single-strategy approaches. This is why
we explore a range of investment strategies in
our portfolios.
Increasing the diversity of single-stock
positions
Increasing the breadth of a portfolio means
increasing the number of independent bets,
not just increasing the number of bets. It is
therefore important to make sure that single
stock positions are diverse and do not load up
12
Investment
Styles
Short-term
Trading
Strategies
Market
Timing
Macro
Economic
Exposures
Trading
Costs
Fundamental
Company Research
Figure 9: The Case for Unconstrained Portfolios Constraints Can Hinder Active Weights in
Following Forecasts
Ideally, active weigths should closely follow forecasted return
3%
transfer coefficient 0.98
Active Weights
2%
1%
0%
1 %
2 %
3 %
High
Low
Active Weights
3%
transfer coefficient 0.31
2%
1%
0%
1 %
2 %
High
Low
Figure 10: The Case for Unconstrained Portfolios Constraints Can Hinder Active Weights
in Following Forecasts
Transfer coefficients for different implemenations of a forecast
1
0.5
0
long/short,
unconstrained
long-only,
unconstrained
long-only,
market cap neutral
long-only,
multiple constraints
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Active Management
References
Alexeev, V. and Tapon, F. (2013) Equity
portfolio diversification: How many stocks
are enough? Evidence from five developed
markets
Blake, Lehmann and Timmermann (1999),
Asset allocation dynamics and pension
fund performance, Journal of Business, 72,
429461
Casey Quirk, 2013, Life After Benchmarks:
Retooling Active Asset Management
Clarke R., de Silva, H. and Thorley, S. (2002),
Portfolio constraints and the fundamental
law of active management, Financial Analysts Journal, 58 (5), pp 4866
Cohen, R. B. and Polk, C. and Silli, B., (March
15, 2010), Best Ideas. Available at SSRN:
http://ssrn.com/abstract=1364827 or
http://dx.doi.org/10.2139/ssrn.1364827
Coggin, T. D., Fabozzi, F. J. and Rahman, S.
(1993), The Investment Performance of US
Equity Pension Fund Managers: An Empirical
Investigation. The Journal of Finance 48,
pp 10391055
Cremers, M. and Petajisto, A. (2009), How
Active is Your Fund Manager? A New Measure That Predicts Performance, AFA 2007
Chicago Meetings Paper; EFA 2007 Ljubljana
Meetings Paper; Yale ICF Working Paper No.
06 14
Daniel, K., Grinblatt, M., Titman, S., and
Wermers, R. (1997), Measuring Mutual
Fund Performance with Characteristic-Based
Benchmarks, Journal of Finance, Vol. 52,
Issue 3, pp. 1035 1058
14
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Active Management
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Active Management
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15
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