Global equity investing:

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1 Global equity investing: Insights into a better portfolio

2 Equity investing: Insights into a better portfolio...the unique qualities of equity make it a likely building block of most asset portfolios for the foreseeable future. towerswatson.com/equity-investing 2 towerswatson.com

3 Contents 06 Section one: Portfolio construction 08 Best-in-class equity structure What is best practice when considering equity portfolios? 16 Using smart beta in equities Smart beta can greatly improve an investor s ability to achieve its objectives 20 Understanding emerging market equity How to best access the expected growth in these markets 25 Low volatility equity strategies should you include them in your portfolio? These strategies target market returns but with much lower risk 30 Section two: Manager selection 32 Assessing investment skill in equity managers A necessary task prior to making any investment and as part of an ongoing monitoring process 40 Do not hire managers for past performance More evidence of why this approach can lose value 43 Quantitative investing will quants strike back? Our current views on quantitative investment strategies 48 Concentrated equity products Why we generally prefer them to diversified products 52 Low volatility equity from smart idea to smart execution How to avoid the potential pitfalls with this investment idea 55 Sustainability in investment research a pragmatic approach Adding transformational change to the asset owners agenda 56 What to look for in a passive manager Rigorous qualitative research can lead to better outcomes 60 Section three: Manager monitoring 62 Benchmarks matter It is important to ensure that they continue to be appropriate 66 What results should dictate firing a manager? At what point is the result so bad that you just have to move on Equity investing: Insights into a better portfolio 3

4 4 towerswatson.com It is hard to find managers capable of sustained outperformance, combine them in a risk-proportionate portfolio and manage this through different economic and market conditions.

5 Introduction Ever since trading began in 17th century coffee houses, equities have provided an efficient means of raising capital and transferring ownership. Every day, billions of shares change hands, each of them representing an ownership interest in a business. Critically, the clearing price depends upon the collective opinion of investors about the future cash flows of these assets. Of course, future returns are not certain. It is the dissenting views over future income streams that create the opportunity to produce outperformance. And that creates the challenge, and also the opportunity, for the manager researcher and investment committee to find skilled investors that can produce superior returns on a sustainable basis. It is hard to find managers capable of sustained outperformance, combine them in a risk-proportionate portfolio, and manage this through different economic and market conditions. This task is complicated by many factors, such as change in the sources of uncertainty when predicting investment outcomes, evolution within financial markets leading to the creation of analogues to direct equity investment, globalisation and technological innovation all of which may reduce inefficiencies in market pricing. Nevertheless, the unique qualities of equity make it a likely building block of most asset portfolios for the foreseeable future. Indeed, with fixed income yields at historical lows, it is incumbent on investors to improve the chances of asset growth from their equity portfolios. In this compendium of articles, we provide practical insights about three functional areas in which asset owners typically operate: portfolio construction, manager selection and manager monitoring. I hope you will find these articles a thought-provoking and practical aid to understanding how to construct an equity portfolio, and select and evaluate its managers. If you have questions on any of the articles, please contact either your usual Towers Watson consultant, or contact me. James MacLachlan Global Head of Equity Manager Research, Towers Watson Equity investing: Insights into a better portfolio 5

6 Section one Portfolio construction 6 towerswatson.com

7 Investors now have more options than ever to consider when constructing an equity portfolio. With greater choice comes the risk of losing sight of the bigger picture. Investors should therefore begin by creating a framework for equity portfolio construction. We advocate a holistic view of risk and return. We prefer to blend best-in-class active managers with smart beta solutions. The latter can help to efficiently manage portfolio biases or substitute style-oriented active managers at lower fees. Here, we offer some practical considerations around topical areas such as emerging markets and style-based investing. Equity investing: Insights into a better portfolio 7

8 01 Portfolio construction Best-in-class equity structure What next for equities?...we believe this is a good time for institutional investors to revisit their approach to investing in equities and to consider what is best practice when constructing equity portfolios. 8 towerswatson.com

9 Over the last decade or so, there has been an explosion in the available options for institutional investors outside the traditional asset classes of equities and bonds. Asset owners, including those under the advice of Towers Watson, have been diversifying their risk-seeking assets away from the equity risk premium and across other return drivers. However, Towers Watson recognises that the equity risk premium still makes an important contribution to institutional investors long-term returns and that there have been significant developments within equities over the last few years. As such, we believe this is a good time for institutional investors to revisit their approach to investing in equities and to consider what is best practice when constructing equity portfolios. Evolution of equity investing In principle, the task of investing in long-only equities has evolved very little. However, some areas have seen considerable development. For example, the metrics one might consider to assess a company s fundamentals are largely unchanged over the past 80 years, but the availability of this data, the way it is used and the development of broader explanations for market behaviour has dramatically changed. In the last 15 years, the market has witnessed at least two significant market bubbles/cycles with the dot-com bust and the global financial crisis. As a result, investors understanding of behavioural biases has evolved and we have been reminded of the importance of macroeconomic, social and political issues (at least in the developed markets if this was never forgotten in emerging ones). So whilst the task at hand may look similar, the solution and its execution may be very different. The essential building blocks of an equity portfolio have, for a long time, been bulk beta (market capitalisation-weighted passive equity) and alpha (active management). Due to some of the developments discussed above, we can now add another pillar to this framework, that of smart beta. Many of the concepts behind smart beta have been around for some time, often embedded within the investment processes of active managers and rolled up in the reported alpha. However, recent improvements in data availability, quantitative management techniques and lower costs have created the opportunity to isolate these sources of alpha and construct dedicated smart beta products. Figure 01 provides an indication of just how rapid the growth of smart beta has been. Figure 01. Number of low volatility equity products over time Source: evestment Alliance Methodology: Analysis based on searching for equity products on the evestment Alliance database containing the terms low volatility or defensive The main objective of smart beta is to capture a particular risk premium for a low cost. These strategies are expected to improve investment efficiency relative to bulk beta and aid portfolio construction (see Using smart beta in equities 1 for further information on this topic). When considering the use of smart beta, investors must research the validity of the risk premium or smart beta strategy as there can be many different strategies and definitions. Care also needs to be taken in implementation as there is now many implementation options for broadly similar strategies and differences in implementation can lead to very different results. Towers Watson s smart beta research team has completed extensive research in this area and can assist investors through this process. Equity investing: Insights into a better portfolio 9

10 01 Portfolio construction Importance of portfolio construction Questioning and examining the ability of equity managers to construct portfolios is something that asset owners have been doing, relatively routinely, for a long time. However, given the developments we have seen in equity investing, it is now also important for asset owners themselves to have a robust portfolio construction process. It is no longer generally considered sufficient to have an allocation to bulk beta and one or two active managers to construct an equity portfolio. The onus is now firmly on the asset owner to develop their own portfolio construction skills, or partner with third parties. The need for multiple products As investment markets broaden and deepen, the breadth of opportunity around the world has become vast and complex. To access these opportunities, asset owners should consider multiple products across the building blocks available to them (bulk beta, smart beta and alpha). Smart beta and portfolio construction There are various different types of smart beta strategies, including fundamentally weighted indices and risk weighted indices. There are also thematic approaches that would give the investor exposure to a particular long-term driver such as scarcity of natural resources. Different types of smart betas come with different portfolio characteristics, structured product investors should pay greater attention to the associated implications for risk. Style diversification Active managers have a wide variety of investment styles, philosophies and opportunity sets. Single word descriptors, such as value and growth, often used by investors to describe managers approaches, are inadequate. Investors need to understand the approach of the active manager in detail and build sufficient diversification across the full spectrum of investment styles. In addition, investors should determine the extent to which the alpha is driven by the same underlying style risk premium that can be captured (at lower cost) by a smart beta alternative. In reality, far greater diversification is often required than investors typically expect (see Figure 02). Equity market returns do not follow the standard statistical pattern of a normal distribution as demonstrated in Figure 03. More unusual price movements are observed in equity markets with greater frequency than a normal distribution would suggest and this further supports the argument for increased diversification. Asset owners need to take a holistic view when constructing portfolios, building diversified exposure to multiple opportunities (risks) through multiple products. To use all of the tools described, portfolio construction skill becomes an essential pre-requisite to building robust long-term risk-proportionate equity portfolios. Figure 02. Benefits of diversification in a manager structure Assuming skilled managers expected probability of meaningful underperformance from the overall structure at some point over a 10 year period 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% For example, to reduce the likelihood of 10% underperformance to less than 10%, at least eight managers are needed 0% Number of managers Probability of at least: 5% underperformance 7.5% underperformance 10% underperformance 15% underperformance Probability of underperformance from the overall structure decreases rapidly initially. Assuming you can find enough high conviction managers there is a strong case for including at least 4 managers in a manager structure to protect against the possibility of extreme underperformance. Probabilities are approximated assuming an individual manager tracking error of 5% pa, a net information ratio of 0.33, an average manager active correlation of 0.3 and a normal distribution of manager returns. Underperformance is defined as a peak to trough cumulative, not annualised. Figure 03. Daily price movements 20% 15% 10% 5% 0% -5% -10% -15% -20% Observed S&P500 distribution Normal distribution towerswatson.com

11 Portfolio construction considerations To generate superior long-term returns, we believe that asset owners require skill in manager selection and portfolio construction. Best-in-class manager selection is required to identify skilled active managers from a universe of many thousands of competing products. Similarly, the number of smart beta products has also been increasing rapidly, meaning expertise is also required to select the most appropriate smart beta approach. Simply identifying the beta and using any product that will give you exposure is not sufficient and can have negative consequences. We believe portfolio construction should include the principles outlined in Figure 04 below. Figure 04. Portfolio construction principles Principle Holistic view of return driver framework Integration of smart beta Use of best-in-class active managers Appropriate diversification Risk and scenario analysis Timely decision making Contrarian hiring and firing Incorporating longer-term views of equity market risk factors and current market conditions Continuous and dynamic Rationale/benefits Ensure returns from smart beta and alpha are expected to come from differentiated return drivers Low-cost solution allows better use of fee budget Facilitates targeted use of (potentially more expensive) alpha strategies Enables asset owners to change portfolio characteristics to suit prevailing market conditions more simply, with lower cost Focus on best-in-class opportunities Niche alpha strategies as beta exposure is gained elsewhere Consider long-short alongside long-only Commission new strategies from skilled managers that are expected to offer improved risk/reward Combining smart beta and multiple alpha strategies to achieve more efficient diversification Risk management framework in place Consideration of scenario analysis to account for non-quantitative risk metrics (such as sentiment, political, social) Capitalise on market volatility and act decisively to take advantage of opportunities or control risk Academic studies have shown and behavioural analysis supports the view that investors often destroy value by hiring managers with good performance, and firing managers with poor performance. Conversely a contrarian approach should add value 2,3 Portfolios should reflect longer-term capital market views in the context of current market valuations. Towers Watson s views are provided by its Global Investment Committee and Asset Research Team Consideration given to attractiveness of style risk factors (see Towers Watson s articles on Value investing 4 and Low volatility equity 5 ) Ongoing monitoring of the underlying strategies and the combined portfolio Consideration of portfolio rebalancing Equity investing: Insights into a better portfolio 11

12 01 Portfolio construction Expanding further on some of the key points in Figure 04: The impact of using appropriate smart beta products on an overall fee budget can be significant. Allocating a material proportion of assets to low-cost products frees this budget to allocate to best-in-class, highly active strategies. It is important to use best-in-class active managers. The best specialist equity managers are often found in boutiques that the investors have established to provide greater focus. In some cases, they may be managing money for high-net-worth individuals or running hedge funds. Often the mind-set or skill-set of these investors is different. For example, high-net-worth managers tend to think in terms of absolute risk rather than relative to market indices. Hedge fund managers often place a different emphasis on risk management techniques but can sometimes be persuaded to apply their approach to long-only products. Significant research resource is required to find these skilled managers. Investing with them may require tolerance for portfolios which have very high relative risk (but not necessarily absolute risk) and are potentially highly concentrated. In addition, the asset management firm is often not a recognised brand name. Studies have shown that portfolio managers typically add value in their high conviction stock picks but often destroy value with the unintended underweight positions in the portfolio. Having more concentrated portfolios with assets focused in the managers highest conviction ideas should offset unintended underweight positions and lead to better outcomes. (See Towers Watson s article Concentrated equity products for further information.) 6 Diversifying across these products and using risk management frameworks to construct portfolios is important as these strategies can exhibit strong style biases due to their focused approaches. Style or beta exposures can overwhelm alpha if not managed properly. In the five years since the financial crisis we have seen the extent to which styles have diverged (see Figure 05), and this style risk needs to be controlled. A risk management framework can help investors to consider, manage and exploit the various risks discussed above, such as market, style, macro and political risks, sentiment and manager selection risks. Figure 05. Divergence of style returns Cumulative relative returns 150% 125% Growth 100% 75% 50% Value The impact of using appropriate smart beta products on an overall fee budget can be significant. 25% Value Quality 0% Value Growth Value -25% -50% Quality -75% Dot-com 2000 bear market 00 s bull market Global financial crisis Source: Style Research, Towers Watson All returns as in US$ measured relative to a market capitalisation portfolio of developed market stocks. Style portfolios are the top quartile of stocks selected from a developed market universe based on a composite ranking of typical fundamental traits associated with that investment style (for example high earnings yield, high ROE or high trailing earnings growth). Portfolios are rebalanced quarterly and market capitalisation weighted. The times periods are defined as: dot-com 01/02/1996 to 31/03/2000, 2000 bear market 01/04/2000 to 30/09/2002, 00 s bull market 01/10/2002 to 31/10/2007, global financial crisis 01/11/2007 to 31/10/ towerswatson.com

13 Complexity and governance It is reasonable to ask is this additional complexity worth it? We have advised clients for many years to either simplify their strategy or raise their game. At one end of the spectrum is a market capitalisation passive portfolio that is suitable for many investors. However, if asset owners are going to compete effectively for investment returns, they should consider every tool available and aim for best practice. Whilst there are greater expected rewards from this approach, it requires more internal governance and portfolio construction skill from the asset owner. Therefore, this approach may not be suitable for everyone. Asset owners should determine what level of complexity is appropriate, given their requirements and their governance levels. If necessary, efforts can be made to increase or decrease the internal governance levels, as required. Figure 06. Internal skill central to building high governance portfolios Bulk beta Alpha (manager skill) Internal portfolio management skill Smart beta Figure 07. Impact of governance levels Low Governance High Low Complexity High Bulk beta Broad global Bulk beta, smart beta, alpha Niche strategies Lower Expected returns/ financial efficiency Higher Equity investing: Insights into a better portfolio 13

14 01 Portfolio construction Towers Watson s role Figure 08. Model portfolio performance Unconstrained equity model portfolio Performance net of fees Performance data shown since inception, as at end June 2013 Benchmark: MSCI AII Country World Index Inception date: 1 January 2005 Base currency: US$ Tracking error Net information ratio +1.9% pa 3.4% pa 0.6 Towers Watson works with asset owners in many different ways to achieve their objectives. Towers Watson s mission is to help our clients make and implement the best possible investment decisions to help them achieve their specific investment objectives. In international equities, we aim to augment our clients own internal resources and give them access to the depth and breadth of our global research teams. As a key business principle, we will always deliver our services to our clients in the fashion that is most compatible with their governance structures, preferences and beliefs. For example, for clients with large internal teams of experienced investment professionals, Towers Watson s role may be to supplement the research carried out by our clients and to share our insights on managers and portfolio construction. For other clients we play a more active role in recommending tailored portfolio configurations, but with decision-making retained by the client. And in some cases (in the US and UK at least), our smaller clients have formally delegated portfolio construction and manager selection to Towers Watson. Regardless of the delivery mechanism, the underlying research and portfolio construction process are the same. And so is our commitment to giving our clients an edge in a highly competitive environment. 14 towerswatson.com

15 Towers Watson has demonstrated success in equity portfolio manager selection and portfolio construction. In particular, we have highlighted the long-term track record of our unconstrained equity model portfolio that is constructed from best ideas around the world. Example equity portfolio With an internal portfolio management capability, asset owners can employ the full range of portfolio construction principles and approaches discussed here. As an example, we have blended the results of the unconstrained equity model portfolio, the performance of some of our favoured long-biased specialist activist managers and three smart beta portfolios. The results are as follows: Construction of the portfolio can be tailored to suit Annualised alpha 3.7% Tracking error 4.0% Information ratio 0.94 Approximate fee 0.9% investor preferences. For example, a desire for lower cost would most likely employ more smart beta and less specialist or highly active long-only managers. A lower absolute risk solution would probably use certain types of smart beta and potentially more long-short managers but fewer high beta long-only managers. Developments in equity markets and the industry have added complexity and breadth, in terms of available products and portfolio construction tools. Conclusion Whilst investors have typically been diversifying away from equities in recent years, it is important to recognise that the equity risk premium remains an important driver of investors returns. As such, we believe investors should revisit their approach to constructing equity portfolios to ensure that it keeps pace with the opportunity set around the world and takes full advantage of the new innovations seen in the industry. Developments in equity markets and the industry have added complexity and breadth, in terms of available products and portfolio construction tools. Most notable is the relatively recent rise of smart beta. In a highly competitive world, we believe asset owners should simplify their strategy (for example, go passive) or raise their game, in order to deal with this complexity and benefit from it. Asset owners therefore need to consider whether they have the appropriate internal expertise to adopt a best-in-class portfolio construction approach. If insufficient governance is a constraint, then partnering with a third party may help overcome any gaps. References 1 Using smart beta in equities. Towers Watson Limited, Replacing managers for performance reasons. Towers Watson Limited, Goyal, A. and Wahal, S. The Selection and Termination of Investment Management Firms by Plan Sponsors, Value investing an old idea, but probably a good one. Towers Watson Limited, Low volatility equity from smart idea to smart execution. Towers Watson Limited, Concentrated equity products why we generally prefer them to diversified products. Towers Watson Limited, Equity investing: Insights into a better portfolio 15

16 01 Portfolio construction Using smart beta in equities There is strong evidence that viewing markets as simple systems is wrong. And yet investors continue to use models based on this view of markets to make investment decisions. This creates opportunity for those investors that are able to think beyond these models. A prime example of such a model is the Capital Asset Pricing Model (CAPM). This model embraces beta as the sole measure of risk and says (under numerous, somewhat unrealistic assumptions), that the market capitalisation-weighted equity portfolio is the optimal investment strategy for equities. Figure 01. The alpha/beta continuum Bulk beta Smart beta Alpha Smart beta is about thinking beyond the CAPM model. By seeking to exploit the behavioural biases that affect investors and capture risk premiums outside the CAPM framework, these strategies have the scope to be valuable additions to the tools in an investor s toolbox, be it for portfolio construction, risk management, cost management, or as alternatives to a passive market capitalisation index strategy. Market capitalisation passive Diversifying Thematic Systematic Stock selection Market timing Here, we explain some of the main advantages of using smart beta but also address the risks and requirements to use it successfully in an equity portfolio. 16 towerswatson.com

17 What is smart beta in equities? We divide smart beta strategies into three broad groups: diversifying, thematic and systematic. Diversifying smart beta Assets that provide diversification to an investor s existing portfolio are valuable. However, directly investing in these assets (for example, infrastructure or real estate) can be complicated and, in some cases direct investment is too illiquid to be viable for an investor s portfolio. A properly structured portfolio of listed equities allows an investor the potential to gain exposure to these diversifying assets by owning companies that are exposed to the long-term underlying economics of these assets. Thematic smart beta The objective of thematic smart beta is to benefit from secular shifts in financial markets. We believe that financial markets are too focused on the short term and struggle to consider the potential range of future outcomes that current uncertainties create. This results in the mispricing of risk for long-term themes and potential secular changes. Thematic smart beta accesses this mispricing by investing in a portfolio which targets themes or groups of themes, such as the development of the emerging markets or future resource scarcity. For investors with a sufficient belief framework and governance structure these strategies may be used to incorporate some of the themes in a portfolio as described in our recent Secular Outlook 1 paper. Figure 02. Company variations tend to mean-revert over some time period Overvalued Fair value Investors extrapolate good news Over time companies are fairly priced, but not all companies are fairly priced all the time Systematic smart beta Systematic smart beta aims to exploit recurring market opportunities that are expected to persist over time. Key drivers of smart beta tend to be the rebalancing effect and risk premiums that have been well documented. 1. Rebalancing effect. The observation that market participants are driven by the emotions of fear and greed is widely accepted. Both are powerful forces and to some degree all financial manias (both bull and bear) can be explained through this lens. The result is self-reinforcing feedback that moves market prices to extremes in the short term followed by a return to more normal conditions over the medium term. Put another way, momentum moves prices away from fair value in the short term and prices mean-revert towards fair value in the medium term. Investment strategies that weight securities by their market capitalisation (both passive and active) are vulnerable to the risk generated by these effects. Securities that have performed well become large weights in the portfolio while the prospects for future relative underperformance increase. By using a different weighting methodology (which is lowly correlated to the change in price) a rebalance premium can be extracted from this momentum/mean-reversion effect in the market. In essence a buy low, sell high discipline is systematically imposed on the strategy. We believe that this effect is likely to persist over time but it will not necessarily be beneficial over all time periods or rebalance frequencies depending on the market environment and transaction costs. 2. Capturing risk premiums. There is a lot of academic research identifying return opportunities from certain types of securities that are periodically mispriced, for example, the mispricing of value stocks allows investors to earn a value premium. These premiums result from market participants being less willing to own certain types of companies for a number of reasons linked to behavioural biases or principle-agent conflicts inherent in the business models of some market participants. Therefore, those investors that are able to own the securities of those undesirable companies are typically able to earn a premium for doing so. Undervalued Investors overreact to bad news As with any premium it is important to consider the risks for which that premium is compensation and to recognise that premiums can be both negative and positive for long-term periods. Source: Towers Watson Equity investing: Insights into a better portfolio 17

18 01 Portfolio construction Using smart beta in portfolio construction In addition to risk and return characteristics of a specific smart beta, these strategies can also be useful portfolio construction tools. From a portfolio construction perspective, its role is often broadly described by a combination of the following three reasons. 1. Replacement for active management. Some active managers use strategies that are largely smart beta in nature, or are closet indexers to a style index while charging active management fees. An example of this would be an active manager that employs simple value screens to construct a value strategy. If there is no incremental alpha beyond the screening then such a strategy is merely capturing the value premium. Rather than paying active fees, this strategy could be replicated at a lower cost using a smart beta approach. Figure 03. Reasons to use smart beta Replace active management 2. Remove an unwanted bias or completing a portfolio. Finding active managers that are able to generate sustained outperformance is not easy. Once such managers are identified and combined together in a portfolio there may be residual undesirable biases or risks. Smart beta provides an approach to address this issue. Consider a portfolio of active managers that create concentrated portfolios based on their best investment ideas. All things being equal, such a portfolio might be expected to exhibit a small company bias (there are many more small companies than large ones) that might be undesirable if the overall structure is measured against a market capitalisation benchmark. To resolve this, an investor could use a smart beta strategy that has a bias to larger companies. This offsets the unwanted bias at the portfolio level while allowing the investor to retain control, without constraining the selected managers. 3. Creating additional governance capacity. Governance is the amount of investment decisions an investor is able to effectively make. We believe an investor is most likely to achieve its objectives when its portfolio reflects its level of governance. If smart beta reduces the governance requirement of the equity portfolio, an investor can spend this governance saving on new strategies that would previously have exceeded its governance budget. Governance saving Portfolio completion Governance is consumed by active managers because they repeatedly require close monitoring. Therefore, switching from active management to smart beta reduces a portfolio s governance requirement while maintaining its overall biases and risk-premium exposures. Conversely, a market capitalisation passive portfolio has very low governance costs. Replacing such a portfolio with smart beta will normally increase the governance required because smart beta requires some governance, albeit with a different focus to a traditional active or passive portfolio. 18 towerswatson.com

19 While it brings new governance demands, if used effectively, smart beta can greatly improve an investor s ability to achieve its objectives and so merits its place in the investor s toolbox. Decisions and responsibilities An investor that uses smart beta assumes greater responsibility for the investment process used in its portfolio. The asset manager in a smart beta approach is often implementing a set process selected by the investor. This is a departure from active management, where the active manager is responsible for the approach followed in order to deliver a particular objective, such as the outperformance of a particular index. By their nature, smart beta strategies can have relatively high active risk, and investors must therefore fully understand and buy into the rationale of a smart beta strategy before using it. This is because poor decision making (hiring and firing) can erode the gains of an otherwise successful strategy as easily in a smart beta strategy as in an active strategy. Risk oversight and monitoring Constructing a smart beta portfolio requires a level of risk management comparable to the construction an active manager portfolio. What to monitor depends on the smart beta approach being followed. Examples include: a. Market conditions: These may present a headwind or tailwind for certain strategies. For example, compressed valuation spreads may present a more challenging environment for a value strategy. b. Crowding: Many investors pursuing a common strategy may create endogenous risk similar to the event of 2007 when active quantitative investors using very similar strategies suffered large losses. c. Evolving biases: As markets evolve, the diversity benefits of combining different smart betas in a portfolio, or their fit with active managers, will vary over time. Conclusion The smart beta concept has significantly expanded the tools available to an investor, particularly within equities. While it brings new governance demands, if used effectively, smart beta can greatly improve an investor s ability to achieve its objectives and so merits its place in the investor s toolbox. References 1 Global Investment Commitee: secular outloook 2013 assimilating thematic thinking, Towers Watson Limited. Equity investing: Insights into a better portfolio 19

20 01 Portfolio construction Understanding emerging market equity Emerging market equities where are we now? While the emerging markets (EMs) theme seems to come in and out of fashion every few years, the thesis for taking advantage of the long term, yet volatile growth that these markets are forecast to deliver remains robust. Nevertheless, many investors maintain a structural underweight to this area both specifically in their equity allocation and asset allocations, more broadly. Although EMs represent almost 50% of the world s GDP, their share of world equity market indices is only about 11%, and they also tend to represent a substantially smaller portion of most institutional equity portfolios. For example, BlackRock indicated recently that the average US investor only has a 5% allocation to EMs. Anecdotally, we believe this low allocation may be fairly representative of the wider institutional investor base. We believe that investors should be considering their current allocations to EMs. Structure of the emerging markets and indices One of the first things for investors to understand when they consider the EMs is the contrast between the breadth of the markets and the concentration of the MSCI emerging market (MSCI EM) index. Developed market investors often think of EMs as a somewhat homogeneous group, characterised (simplistically) by high growth and higher volatility, but lower governance standards. In reality, the EMs represent diverse countries, spread across five continents with different cultures, languages, political systems, regulatory regimes, demographic profiles and stages of development. When frontier markets (markets that are not classified as developed or emerging) are included, this universe becomes more diverse. 20 towerswatson.com

21 While there are many thousands of companies listed in EMs, for reasons such as liquidity, the MSCI EM index contains only about 800 stocks. The China A-share market is also not represented in the index, as it is not yet a freely traded market. The MSCI EM index has some notable areas of concentration in terms of stock, sector and country. For example, the largest four countries in the MSCI EM index represent about 56% of the index, despite the index containing 21 countries. Furthermore, the index is typically dominated by a relatively small number of very large companies. Figures 01 and 03 illustrate the concentration in certain parts of the market. As the charts show, the energy, financial and telecommunication sectors comprise a small number of large companies that are, perhaps, over-represented in the index. Conversely, there are many industrial, consumer, and healthcare companies that seem under-represented. Figure 01. Sector concentration in emerging markets Utilities Telecommunication services Information technology Financials Healthcare Consumer staples Consumer discretionary Industrials Materials Energy % of companies in universe MSCI EM weight Equity investing: Insights into a better portfolio 21

22 01 Portfolio construction State Owned Enterprises (SOEs) Many companies in emerging markets have large controlling shareholders. These may be families, entrepreneurs or state-controlled entities. Companies that are partly owned by these state entities are called State Owned Enterprises (SOEs). Many of the large energy, financial and telecommunication companies that dominate the index tend to be SOEs. Figure 02 shows the dominance of SOEs in emerging markets compared to developed markets. Investors question whether SOEs are always run for the benefit of the minority shareholder or whether they are the most efficient allocators of capital. We can also see from Figure 03 that similar levels of concentration exist at the country level. Investing in emerging markets Many institutional investors seek to invest in emerging markets to access the expected growth in these countries, particularly through increasing consumption. However, as we have seen, EM indices may give investors higher concentration than they might expect in companies that are not purely exposed to these drivers of EM growth. For example, a large portion of the index comprises energy/commodity companies and exporters, which may be more reliant on global growth (rather than EM growth) and SOEs which may not deliver the desired level of shareholder return. Accessing EM equity The usual ways of accessing equity markets apply similarly in emerging markets. There are investment options for traditional bulk beta (passive market capitalisation approaches), smart beta and alpha (active managers). However, there are important considerations for implementation which are specific to emerging markets. Passive market capitalisation approach Market capitalisation weighted passive exposure is now reasonably cheap and offers a high standard of index tracking (although perhaps not as close as in developed markets). Institutional passive product fees have fallen in price, with a standard fee for a US$50 million mandate now typically below 0.15% per annum. These products offer broad exposure to emerging markets and are, by their nature, not capacity constrained. However, we remain concerned about passive exchange traded funds (ETFs) for emerging markets equities, as these tend to have high fees (a leading EM ETF has a total expense ratio of 0.67% per annum) and have displayed fairly high tracking errors over time. Figure 02. Proportion of SOEs in market indices 30% 25% 20% 15% 10% 5% 0% Emerging markets Developed markets Share of state companies in market capitalisation Figure 03. Number of companies and index weight by country Morocco Hungary Czech Rep Egypt Peru Philippines Colombia Poland Turkey Chile Thailand Indonesia Malaysia Mexico Russia India South Africa Taiwan Brazil Korea China % of companies by listing (excluding A-shares) % of companies in universe MSCI EM weight 22 towerswatson.com

23 Passive market capitalisation products represent suitable implementation options for many clients for reasons such as simplicity, low cost and broad exposure. However, for reasons set out in this article, Towers Watson believes that other smart beta or active management approaches may, in theory, be preferable. Smart beta The main objective of smart beta is to capture a particular risk premium for a low cost. These strategies are expected to provide superior investment efficiency than bulk beta (passive market capitalisation). Please see Towers Watson s article Using smart beta in equities 1 for further information on this topic. These smart betas include value-weighted strategies, low volatility strategies and diversification-based strategies. All require careful consideration and have implications for portfolio implementation. Fees for these strategies are more expensive than their developed market equivalents but, at around 0.30%, represent reasonable value in emerging markets. Active management Active management is, in theory, very attractive in emerging markets. It is often argued that EM equity is a less efficient asset class, in part due to the issues discussed above, but also because sell-side analyst coverage has typically been lower in emerging markets (although this is increasingly less the case). Active managers are potentially better able to assess the quality of company governance and the actions of management, which can be very important in emerging markets. Active managers may also have freedom to invest in emerging market stocks that are listed on developed market stock exchanges. These can include multi-national companies with high emerging market presence/exposure. But more importantly, genuine emerging market businesses that have, for various reasons, chosen to list elsewhere. Active managers are therefore able to select those companies that are most exposed to key emerging market drivers, which may not be some of the large EM index stocks. However, there are also some structural challenges facing active management in emerging markets. 2. Large asset bases: Large teams typically require larger asset bases to support them. Additionally, they are often found in large businesses rather than specialist boutiques. 3. Capacity problems and reduced alignment: Large firms with weaker alignments of interest may be more motivated to grow their asset base. Indeed we have observed that many of the leading EM investment managers are now closed to new business or have prohibitively large asset bases. Figure 04 demonstrates the reduction in opportunity set experienced when managers grow their assets under management in excess of US$20 to 30 billion. There are many managers that are of this scale. 4. High fees: There is a relatively limited universe of skilled and experienced emerging market managers compared to US or global equities. As more assets flow in to emerging markets this limited supply has greater demand. As such, standard fees are high. Screening the evestment Alliance database 2 global EM equity managers suggest an average annual fee for a US$50 million account of 0.92%. This compares to 0.73% for the global equity universe. It is not obvious that this higher fee is justified by higher (expected) alpha. 5. Transaction costs tend to be higher: This is another hurdle that active managers need to overcome to deliver added value net-of-fees to investors. Figure 04. Percentage of universe stocks that are investable Based on 1% position at various assets under management, given the desire to hold <5% of a company s market capitalisation 100% 90% 80% 70% 60% 50% 40% 30% 1. Large teams: Diverse markets, cultures and languages often lead managers to hire more staff to gain broader local knowledge. Bigger teams can typically present more challenges to communication and culture and can potentially become bureaucratic. 20% 10% 0% ,000 2,000 5,000 10,000 20,000 30,000 Assets under management (US$ millions) Frontier markets EM small capitalisation EM Equity investing: Insights into a better portfolio 23

24 01 Portfolio construction Types of active managers Active EM managers tend to fall into two broad categories. The first are those that provide broad market coverage across most sectors and regions in the market. These products tend to be larger and more scalable, and often come with modest tracking errors. Skilled managers can be found in this category although few are expected to deliver attractive returns net of fees, given the higher fees for the level of risk and capacity issues. The second category comprises managers that are less benchmark sensitive and focus more on maximising long-term absolute returns or accessing a particular theme (such as domestic EM growth). These types of managers will often eschew, for example, global commodity companies, large index constituents or perhaps SOEs. Their portfolios can therefore often look very different to market indices and have high tracking errors, and perhaps biases to smaller capitalisation stocks or certain sectors (for example consumer goods) relative to the EM index. How Towers Watson can help investors Towers Watson s Asia and emerging market research teams have conducted extensive research into these markets and the investment managers that operate in them. We believe that the emerging markets offer exciting long-term investment opportunities, but implementing investments in this region is difficult. More detailed understanding and awareness of the key issues is required. Despite the challenges, we have identified a select group of active managers that we consider to have attractive value propositions net of fees. These managers, together with passive and smart beta offerings, may provide investors various ways to exploit the attractive structural opportunity that we believe emerging market equities present. References 1 Using smart beta in equities. Towers Watson Limited, As at Q As well as global EM managers, there are various regional managers and frontier market managers. Towers Watson has research coverage in this area, but these investors rarely have the size of allocation or governance to construct portfolios containing many regional managers. Frontier markets In a similar manner to emerging markets, frontier markets offer a broad and diverse opportunity set that we believe can benefit from long-term growth drivers. However, lack of liquidity, relatively poor governance standards and earlier stages of economic development make these markets unattractive for many investors. We believe that significant investor skill is required when investing in these markets due to the above constraints and so avoid passive allocations in these markets. We believe that allowing skilled emerging market managers the ability to invest in frontier markets can give further potential for added value in the long term. 24 towerswatson.com

25 Low volatility equity strategies Should you include them in your portfolio? Investors often ask us about low volatility equity strategies. That is hardly surprising, as these strategies target market returns but with much lower risk. While no two low volatility strategies are identical, most share many traits. For example, they often target similar anomalies in the equity market. Here, we ask: Do low volatility equity strategies improve an investor s portfolio? We show that they can in some cases. Even then, these strategies still raise concerns that all prospective investors should resolve before proceeding further. We discuss these concerns, before stating the attributes of these strategies that we tend to seek and avoid. What is a low volatility equity strategy? Many equity managers now run traditional active products and low volatility products. In both cases, they have the same investment philosophy they just apply it differently in each case. With traditional mandates, managers aim to outperform a benchmark, while bearing a similar absolute level of risk. Yet in most low volatility mandates, managers aim to generate a return like the benchmark but with, say, 30% less risk. This risk/return profile for low volatility products resonates with many investors who feel unable to bear large losses. 1 While products with this risk/return profile differ to some extent, they resemble each other in the main ways. After all, they tend to exploit the same perceived systematic mispricings of stocks. One difference, however, is cosmetic. Managers use different names, often for the same thing. For that reason, the terms low beta, low volatility or even better indices tend to feature, not, small capitalisation value, which often reflects the type of stocks being chosen. 2 (For the sake of brevity, we will refer to them all as low volatility strategies in the rest of this article.) As for similarities, most low volatility strategies target an investment in stocks with low return volatility. They do so because, counter-intuitively, low volatility stocks have historically tended to outperform high volatility stocks on a risk-adjusted basis, and particularly so in some recent years. For that reason, many managers run portfolios that are overweight low volatility stocks and underweight high volatility stocks. We now consider why this counterintuitive performance occurred, and whether it might recur. Equity investing: Insights into a better portfolio 25

26 01 Portfolio construction What is the investment rationale for low volatility equity? As with all systematic active management, the rationale is that investment markets are inefficient and include anomalies that investors can exploit for better risk-adjusted returns. The longer explanation requires some historical context. Clearly, when combined together, all investors own the mix of every conceivable asset. Early investment academics called this mix the market portfolio. 3 As a result, most academics thought that the optimal investment strategy would be to invest in some mix of cash and this market portfolio. This view spawned the use of index funds and diversification across many different assets. More recently, though, many academics have come to see this market portfolio as inefficient. They reason that the earlier assumptions, which resulted in the optimality of the market portfolio, were unrealistic. These earlier assumptions, for example, held that information is without cost to obtain and that investors can always borrow cash without difficulty. With more realistic assumptions, academics have shown that patient investors can outperform the market portfolio, in risk-adjusted terms, by holding mixes of assets in non-market weights. 4 In other words, investors can improve their outcomes by exploiting anomalies. 5 Figure 01. A stock s excess return and its beta in theory and in practice Excess return of stock As derived from classical theory As observed empirically Beta of stock Although not accepted by every academic, theories abound on the evidence and reasoning for different anomalies. These theories often stem from biases in investor behaviour or from constraints faced by rational agents. 6 We now present one such anomaly the low volatility or low beta anomaly framed in both of these ways: People usually prefer to gamble on long-shots than on favourites. Studies show the impact of this bias in different aspects of our lives. In horse racing, data from many decades and countries shows that the average return on a long-shot is dismal, while that on a favourite is only poor. 7 In finance, classical theory calculates a stock s expected excess return relative to cash (see Figure 01). This outperformance relates to the stock s beta, which depends upon the stock s volatility and the correlation of its returns with those of the market. Specifically, classical theory expects high beta stocks to outperform low beta stocks. Yet, in keeping with our general preference for long-shots, regardless of their fundamental value, finance studies show that high-beta stocks underperform the return expected by classical theory, while low-beta stocks outperform those classical expectations. Assuming that these results recur because human behaviour doesn t change, investors choose to overweight low-beta stocks and underweight high-beta stocks in order to outperform on a risk-adjusted basis. The constraints that investors face force them to act as if they seem irrational. Other parties take a different view, even though they use the same evidence and build similar portfolios. They argue that investors face boundaries on how they can act, either through rules or conventions. To circumvent these boundaries, the theory goes, investors generally alter their behaviour in a way that would appear irrational without a prior understanding of the boundaries that they face. One such example comes from Baker et al (2010). 8 They begin with the classical expectations outlined above, based on the portfolio s beta. They then change these calculations to reflect a real-world scenario. Specifically, they assume that markets are rational and that some investors manage their own money and seek to find an optimal portfolio in the classical way. Yet they also assume the presence of another type of investor, which hires an agent (an investment manager) to run its money relative to a fixed benchmark. As a rational agent, this investment manager is assumed to maximise the information ratio for its investor s portfolio a different goal to the other type of investor. What becomes clear from the study is that the interplay between 26 towerswatson.com

27 the different goals for these two types of investor explains much of the historical low volatility bias. Furthermore, these aspects of the real-world scenario are unlikely to change anytime soon, meaning that the low volatility bias may well persist, absent a massive flow of assets to try and capture it. 9 We tend to agree with the academic consensus about anomalies. On paper, it seems that very patient investors can improve their risk-adjusted returns by taking advantage of these anomalies. Experience suggests that doing so in practice is tougher. For that reason, we now discuss some of the implementation challenges. Challenges that investors face when trying to exploit an anomaly At best, some of the following challenges can dilute an investor s outperformance. At worst, they can lead to a major loss of wealth. Prospective investors should therefore satisfy themselves that they can overcome these obstacles before proceeding further. Popularity tends to worsen a strategy s future prospects. Collectively, investors often prefer a certain investment approach, given its recent performance. That can be dangerous, as too much money may be chasing too narrow a part of the market. In August 2007, for example, many quantitative investment strategies suffered when large hedge fund investors scrambled for liquidity. This caused a sharp fall in the prices of some of the large value stocks that were popular in quantitative strategies. In turn, this led to huge losses for some leveraged funds in this area. 10 As it happens, most low volatility strategies have performed very well in the last few years and have attracted assets, which we consider potentially troublesome. For more detail on the recent performance and valuation of these low volatility portfolios, see Low volatility equity: from smart beta to smart execution. 11 Much of an anomaly s excess return occurs at times that make its investors most uncomfortable. Consider the small capitalisation anomaly, for example. The smaller the stock, the tougher it is to sell. This illiquidity makes most investors uneasy, particularly in difficult times, making the timing of hiring and firing managers in this area particularly important. Unsurprisingly, the small capitalisation anomaly seems to provide its greatest risk-adjusted returns for the smallest capitalisation stocks in times of greatest market stress. In order to make their products seem more palatable or investible to investors, managers often trim the investment universe. In doing so, they unduly dilute the likely payoff from exploiting the anomaly. Worse still, many investors cannot withstand protracted underperformance and so may change strategy in these difficult times, just before an anomaly s return potential is realised. Does such a strategy merit inclusion in an investor s portfolio? From now on, we assume that investors believe that: Systematic anomalies can be exploited to enhance risk-adjusted returns 12 They do not want to re-engineer their entire portfolio They have satisfied themselves that they can overcome the challenges that we outlined in the previous section Whether low volatility strategies should form part of the investor s portfolio then depends on its existing arrangements: A low volatility strategy may make sense as a replacement manager for investors with a traditional active equity mandate. After all, low volatility strategies can provide better value for money than many traditional equity mandates in accessing the same equity anomalies. Some strategies go further still and aim to capture many different anomalies within the same portfolio. This approach is reasonable, as long as it remains inexpensive. However, we know of some investment managers that market multi-anomaly portfolios as if they added true alpha, instead of exposing their investors to factors that could be garnered simply and less expensively. When products are marketed in this way, we advise investors to place even more effort than usual on due diligence. No matter how different these products purport to be, many low volatility or low beta strategies look statistically similar. (For example, low volatility and fundamental indexation.) As such, combining two of these strategies in a portfolio would improve risk-adjusted return less than by hiring a different type of skilled active manager. If investors were going to spend their resources to hire another manager, they would probably be better to do it elsewhere. Collectively, investors often prefer a certain investment approach, given its recent performance. That can be dangerous, as too much money may be chasing too narrow a part of the market. Equity investing: Insights into a better portfolio 27

28 01 Portfolio construction Of course, once investors have opted for a low volatility strategy, they must find the specific type of strategy and a suitable manager. As we cannot comment on every manager in one article, we now consider the attributes of low volatility strategies that we generally seek and avoid. As with other strategies, we generally prefer products with lower costs and fees, wherever possible. But what should investors avoid? Investors often measure success too narrowly, using only the average return and variability of returns. Most tests of anomalies measure the average and variability of the returns they generated. This approach is unfortunate, as these tests ignore the fat tailed outcomes that occur in stressed markets, which can cause investors to exit a strategy with a major loss. Worse still, empirical studies show that these strategies generate more very poor outcomes than their respective market capitalisation benchmark. 13 This combination of effects could harm uninformed investors. After all, they could be attracted to low volatility mandates, given their association with lower risk, even though extreme downside events may be more likely than with a pure market capitalisation approach. As is the case in other mandates, investors in low volatility strategies should be able to endure prolonged periods of painful performance. Otherwise, they will not be able to remain invested in the toughest times and so benefit from the improvement in returns that the anomaly generates. Low volatility products expand the options available to equity investors. Even better, some of them give investors cheap access to important investment anomalies. What attributes of low volatility products should investors avoid? While there are some clear exceptions to the following preferences, we generally advise investors to avoid products that: Have been made too investible. We noted earlier that most of an anomaly s excess return seems to arise from the aspects that make its investors uncomfortable. As such, any strategy that only focuses on comfortable stocks may not provide enough excess return to justify its fees over the longer term. We therefore tend to prefer products that do not unduly exclude the smallest stocks from their investible universe. Are highly dependent on an opaque model. Sadly, not every investment manager acts in the best interests of its investors. Of course, there is no link between managers with opaque models and managers that are nefarious. However, managers with opaque models could act improperly and their investors might never know until it is too late. Lo (2001) 14, for example, designs a simple but ultimately evil strategy that could be marketed as a proprietary opaque model. It is designed to perform well in the medium term, accruing assets and income for the manager, before blowing-up in the long term, to the great detriment of the investor. Rely heavily on an optimiser. The traditional concern with optimisers is that they maximise the impact of errors in the manager s forecasts of expected return. 15 However, they can also generate a portfolio with an undue, and often unrecognised focus on a particular factor. As we noted before, such a narrow focus is unwelcome in these strategies. Focus on too narrow a subset of the market. We base this view on our earlier concern that low volatility products can become fragile and prone to asset flows in times of market stress. Conclusion Low volatility products expand the options available to equity investors. Even better, some of them give investors cheap access to important investment anomalies. Even then, these strategies raise concerns that all prospective investors should resolve before proceeding further, such as the focus on too narrow a subset of the market by strategies that are increasingly popular. 28 towerswatson.com

29 References 1 The preference for this mandate raises some broader issues, including some about investment strategy. For example, should loss-averse investors just allocate less to equity? Would the equity allocation change dramatically with a low volatility mandate rather than a traditional quantitative equity mandate? A key consideration is whether the low volatility product produces a sizeable fall in the volatility of the total portfolio. After all, reducing the volatility of a certain product in a portfolio may not reduce the volatility of the portfolio itself by much. However, reducing the expected return of a product within a portfolio will certainly lower the portfolio s expected return. For that reason, an investor may be able to achieve a better overall risk-adjusted return by hiring a traditional equity mandate that targets the same anomalies. The answer to this question will differ by investor, given their existing allocation. However, investors should consider these questions before proceeding with such a mandate. 2 While the index of small capitalisation value stocks has a high beta relative to the broad market index, the same is not true for all of its constituent stocks. As it happens, it is these lower beta stocks that often appear in low volatility products. 3 Sharpe, W. Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance 19 (1964): A broader question also arises at this point. That is, why focus only on cheap equity anomalies? If you wish to be consistent, shouldn t you be considering as many anomalies as possible in your portfolio? After all, many of these anomalies, like the illiquidity premium, may present themselves across multiple assets. For that reason, some expert investment boards now base their investment strategy not on asset allocation but on an allocation of factor exposures (that they implement by investing in certain subsets of an asset class). Ang et al (2009) describe such an approach in great detail. Other investors use risk parity funds to achieve a similar aim, although doing so raises more questions, such as the potential fragility of a risk parity portfolio in the face of steepening yield curves. 5 In equities, for example, see Fama and French (1992) for details of the value-growth and large-small anomalies. (Note that, under specific assumptions, Fernholz and Karatzas (2006) disagree and view the small capitalisation and illiquidity premium as identical.) Carhartt (1997) then considers an additional anomaly, called momentum, while Pastor and Stambaugh (2003) reflect on an anomaly for illiquidity. 6 Brav and Heaton (2002) skilfully show the uncanny similarity between these two types of theory. 7 Snowberg and Wolfers (2010) reflect this consistent bias in more detail and conclude that it likely results from behavioural biases. 8 Baker, M. Bradley, B. and Wurgler, J. Benchmarks as limits to arbitrage: Understanding the low volatility anomaly. Financial Analysts Journal (2011): This form of argument is based on the work of Shleifer and Vishny (1997), concerning the limits of arbitrage. 10 See Lo, A W. Interview by House Committee of Oversight and Government Reform. Hedge funds, systemic risk, and the financial crisis of (13 November 2008), as an excellent account of this period of market turmoil. 11 Low volatility equity: from a smart idea to smart execution. Towers Watson Limited, In this article, we make the distinction between systematic and idiosyncratic anomalies and focus on the former. For example, an investor may have good reason to expect value stocks to continue to outperform growth stocks on a risk-adjusted basis. That view refers to a perceived systematic anomaly. However, the same investor may also have a view on the diverging prospects of two supermarkets, which she does not believe is in the two prevailing stock prices. That latter view refers to a perceived idiosyncratic anomaly. 13 Ang, A. Goetzmann, W N. and Schaefer, S M. Evaluation of active management of the Norwegian Government Pension Fund Global Lo, A W. Risk management for hedge funds: Introduction and overview. Financial Analysts Journal, November/December See Finding the right asset allocation: Is optimisation the solution? Towers Watson Limited, 2012, for further details on why optimisation is often not sensible. Further reading Brav, A. and Heaton, J B. Competing theories of financial anomalies. The Review of Financial Studies (2002): Carhart, M. On persistence in mutual fund performance. Journal of Finance 52 (1997): Fama, E. and French, K. The cross-section of expected stock returns. Journal of Finance 46 (1992): Fernholz, R. and Karatzas, I. The implied liquidity premium for equities. Annals of Finance, January Pastor, L. and Stambaugh, R. Liquidity risk and expected stock returns. Journal of Political Economy 111 (2003): Ross, S. The arbitrage theory of capital asset pricing. Journal of Economic Theory 13 (1976): Schleifer, A. and Vishny, R W. The limits of arbitrage. The Journal of Finance LII, no. 1 (1997). Snowberg, E. and Wolfers, J. Explaining the favorite-long shot bias: Is it risk-love or misperceptions? Journal of Political Economy (2010): Equity investing: Insights into a better portfolio 29

30 Section two Manager selection 30 towerswatson.com

31 In this section, we discuss our framework for assessing investment skill, which we apply consistently across our team of over 50 equity manager researchers in 15 locations. We base our approach on the belief that a qualitative, evidence-based assessment of investment skill outperforms approaches based on proxies for skill, such as past investment performance or the existence of a recognised brand. We discuss several forms of equity portfolio management, their characteristics, when they work, when they do not, and the importance of long-term thinking. Equity investing: Insights into a better portfolio 31

32 02 Manager selection Assessing investment skill in equity managers Assessing investment skill in equity managers At the heart of any decision to employ an active equity fund manager is a belief that the portfolio will produce favourable investment returns above some benchmark. This is commonly known as alpha. At best, the judgment of a manager s ability to produce alpha will be based on a direct assessment of his skill in selecting investments and his ability to put these investments together in a portfolio that efficiently balances return relative to risk. However, there are significant challenges to forming judgments of investment skill that lead many to adopt more easily sourced but spurious surrogates, such as short-term investment performance or a recognised brand, to guide them when forming a view of investment skill. Such approaches can be typical of how retail investors select investment products but should have no place in the professional market. In this article we have set out our beliefs on how investment manager skill should be assessed both prior to making any investment and, equally importantly, as part of an ongoing monitoring process once an investment has been made. Although a number of the examples in this article are taken from the equity sphere, our comments apply across all asset classes and should provide the reader with a framework for assessing both their own investment decisions and the robustness of the advice that they receive. 32 towerswatson.com

33 The perils of past performance Past performance in particular can sound a plausible basis upon which to form an opinion. This is because we are programmed to recognise patterns in nature and to extrapolate what we believe we have observed. However, studies have shown that there is a high degree of randomness in relative investment returns and that to be statistically significant, a performance record should be intact for nearly 15 years. 1, 2 Few investors meet this criterion. Fewer still meet this requirement and have not experienced other changes which have a direct impact on future performance, such as staff turnover or growth in assets under management which can affect portfolio construction. Consequently, we strongly believe that considered in isolation past performance is a poor basis for assessing investment skill. Similarly, it is human nature to want to avoid standing out in a crowd. Investors take comfort from the fact that others have invested with the same manager. As Keynes said it is better for reputation to fail conventionally than to succeed unconventionally. 3 This behavioural bias often causes investors to assign value to a recognised brand that is not based upon the skill of the fund manager or the likelihood of achieving alpha. In fact for a variety of reasons the opposite is very often the case. Selecting a manager is made more difficult because it is possible that a skilled manager will generate poor returns for an uncomfortably long time before his skill again manifests itself. This is true even of great investors such as Warren Buffett who, while amassing his spectacularly successful 45-year track record of compound annual outperformance of 10.86%, still recorded two rolling three-year periods where his relative performance was negative. It is also probable that an unskilled manager will produce positive returns for multi-year periods. Although survivorship bias means that many of these investment failures have been dropped from the databases, there are still many that we could cite as being value destructive over the long term whilst demonstrating rolling three-year periods of positive relative performance. The challenge for investors and advisors is to be able to differentiate luck from skill. 4, 5 Figure 01. Excess returns are random in aggregate -15% -10% -5% 0% 5% 10% 15% This chart presents the expected returns (shaded area) assuming returns are random and normally distributed, and the distribution of actual returns achieved by all large capitalisation US equity portfolio managers (the red line) over the past three years (net of fees at an estimated 0.5%). As can be seen, the realised excess returns have a random distribution with a mean return just above 0%. Source: evestment Alliance, Towers Watson Figure 02. Probabilities of skilled and unskilled investors performance over three years 100% 75% 50% 25% 0% This chart shows the probability of a skilled manager (defined as having a net information ratio of 0.5) and an unskilled manager (defined as having a net information ratio of -0.1) outperforming the market over a three-year period. While the skilled manager has a higher probability of producing positive excess returns it still has a 19% probability of underperforming over a three-year period. Similarly, although not expected to outperform, the unskilled manager has a 43% probability of outperforming in a three-year period. Source: Towers Watson Skilled Unskilled Positive excess returns Negative excess returns...we strongly believe that, considered in isolation, past performance is a poor basis for assessing investment skill. Equity investing: Insights into a better portfolio 33

34 02 Manager selection The process of identifying true skill Explicit determination of investment skill in an equity fund manager is complicated. Differences in investment philosophy, process and execution mean that the analytical framework applied to each manager and product must have a degree of flexibility. Formulaic approaches to assessing skill do not have the sophistication needed to recognise and differentiate the subtle differences in philosophy, process and execution between managers. A focus on the long term is particularly important, as some asset managers appear to rely on the randomness of returns in markets to produce a positive short-term track record, which is then used to market products to advisors and clients who are attracted by short-term performance. As John R Minahan stated while most managers have an investment philosophy statement, in my experience these statements are more often marketing slogans or product positioning statements than they are thoughtful encapsulations of the investment insights an investment process is designed to exploit. Leading to the view that many investment managers are alpha-pretenders. That is, generating positive ex-ante alpha is a secondary consideration for many investment management firms. 6 Figure 03. Excess returns decline as assets grow 30% 20% 10% 0% -10% -20% -30% March 1970 March 1975 Source: Towers Watson March 1980 March 1985 March 1990 March 1995 March 2000 March 2005 March 2010 The scalability of the asset management business model provides financial incentive to grow assets under management beyond the point at which diminishing marginal returns to investors set in. This is a graph of the excess returns generated by one of the largest US mutual funds over its 40-year history based on publicly available information. The size of the portfolio peaked at more than US$100 billion in early Since 2000 the portfolio has more than halved in size and excess returns have begun to expand. The role of investment philosophy To form a view of the investment skill of a manager it is important to build a comprehensive understanding of the three key areas mentioned above. This typically starts with a discussion of the manager s beliefs about what creates investment opportunities, how a process can be constructed that enables the manager to capture such opportunities sustainably, what competitive advantage the manager may have and how this process can be expected to evolve. An investment philosophy is important because we know nothing with certainty. In particular, no one knows what a business will earn or what equity risk premium should be applied in the future. Consequently, investment managers need a relatively constant framework of beliefs to guide them in the formulation and execution of their process. To confirm the underlying philosophy and form a view of its robustness, direct questions may be asked regarding the creation of alpha opportunities, competitive advantages, and so on. Perhaps surprisingly, many managers are unable to address these fundamental issues convincingly. A focus on the long term is particularly important, as some asset managers appear to rely on the randomness of returns in markets to produce a positive short-term track record, which is then used to market products to advisors and clients who are attracted by short-term performance. 34 towerswatson.com

35 Translating a philosophy into a portfolio From as early a stage as possible, it is important to identify evidence that there is logic and consistency between how the investment manager believes alpha opportunities arise and the process through which these are identified and the portfolio constructed. The defined process will also form the foundation for critical assessment of investment skill. This assessment involves discussions with the portfolio manager, and members of the wider analytical team to determine what criteria are considered and how they are applied when making investment decisions. The level of detail must be sufficient to enable the researcher to understand the steps the manager/analyst goes through from idea conception and proof of thesis, to deciding how to weight the investment in the portfolio, and the determination of possible sell triggers. The importance of constructing a comprehensive understanding of the process cannot be overemphasised. Vague descriptions are inadequate for forming high conviction evidence-based judgments. For example, one process description we have encountered stated the process as being investing in companies with sustainable and high return on invested capital and high free cash flow. In this case it would be necessary to know what is meant by high and sustainable. An understanding of how the manager calculates free cash flow is also necessary if the researcher is to verify that the manager does what he says he does. Once the terms have been defined it then becomes possible to screen the portfolio for what at first sight appear exceptions to the stated process, challenge the manager more effectively on his investments and gather the evidence needed to form high conviction views on depth of investment analysis and knowledge. Analysis of the process identifies the primary sources of expected alpha generation. In some products this expected alpha generation may reside with a single individual who has complete responsibility for investment analysis and portfolio construction. Alternatively, other products may involve inputs from many different individuals. For example, one organisation has a team of three global equity co-portfolio managers based in different parts of the world. They source their ideas from the top two quintiles of investment recommendations as ranked by their team of 60 equity analysts, who are themselves scattered across the globe. The majority of products will fall somewhere between these two extremes. Processes that rely on broadly-sourced alpha are often more complicated to assess and consequently it can be more difficult to build similar levels of conviction when compared to less complex processes. Equity investing: Insights into a better portfolio 35

36 02 Manager selection Assessing whether the portfolio will deliver the expected alpha After reviewing the investment process and cross-referencing this with the philosophy, the primary sources of expected recurring alpha generation can be confirmed. Once they have been identified, a decision has to be taken as to whether it is possible to assess the level of skill in the alpha critical functions. In some instances it may be determined that due to limited disclosure from the manager (or for some other reason), it will not be possible to form a high-conviction view of the investment skill and further research may be abandoned. However, in the vast majority of cases, expected alpha generation will be based on the exploitation of a belief through a process for which a framework can be established to assess the level of skill. In the case of equity managers this is usually relatively straightforward and a range of factors that are critical to the successful execution of the process can be identified and measured. The analysis typically starts with a detailed examination of the investments within the portfolio for any obvious inconsistencies with the process. If there are investments that appear to contradict the process then these may be prioritised for discussion. Examining such exceptions deepens our understanding of the process and the manager. Alternatively, poorly performing investments may be selected on the basis that we are likely to learn more from a manager s mistakes than from his successes. Meetings with the appropriate individuals (portfolio manager, analyst, macro specialist, and so on) can then be arranged to discuss the investments identified. Other asset classes can entail a somewhat different approach (indeed not all equity managers fit neatly into the framework set out above). However, regardless of asset class or approach, all require an analysis of the portfolio to confirm consistency with the stated process together with an assessment of whether there are skilled investment professionals who are able to create and evolve a methodology to gain and maintain an advantage. Often, our research meetings will take the form of a conversation regarding the rationale for a particular investment. This provides the portfolio manager or analyst with a blank canvas on which he can illustrate how he reached a decision. This then creates an opportunity to explore the key arguments and to discuss how the rationale has changed through time. A discussion of the risks to the thesis may provide additional insights. Asking some factual questions to which the answer is already known can help to keep the conversation honest. Often there are particular aspects to a process which are worth exploring in more detail. Figure 04. Complex versus simple process structure Complex structure (many alpha sources) Simple structure (few alpha sources) Analysts Portfolio managers Products 36 towerswatson.com

37 ...we are likely to learn more from a manager s mistakes than his successes. The critical point from a research perspective is to have enough knowledge of the underlying investment to be able to follow up on open questions with second, third and fourth questions to expose more of the basis upon which the manager s judgments have been made. It is important to recognise that, at no point in these interviews, do we form a judgment on the attractiveness of the underlying investment. Our sole objective in discussing investments is to gather evidence to support an opinion of the manager s investment skill and ability to generate alpha. We are not attempting to second-guess the manager s decisions, but rather to test the process and the quality of its execution. That is, we do not meet the manager to understand the portfolio, we analyse the portfolio to better understand the manager. It is also good practice to ask for the manager s internal research on the investments discussed. This provides another point of reference to confirm the veracity of the stated process and to assess the extent to which an unsatisfactory investment discussion may be down to poor communication skills. We are not attempting to second-guess the manager s decisions, but rather to test the process and the quality of its execution. Case study 1 We discussed a manager s investment in Kingfisher, a UK-based home improvement retailer. As part of our discussion regarding the investment rationale, the manager suggested that he expected operating profit margins to reach 12%. Through research undertaken prior to the meeting we were aware that in the previous year margins were 6.5% and that during the past 20 years they had never been above 8.8%. Knowing this information enabled us to recognise that the forecast for operating performance was aggressive and led us to drill into the basis for this forecast to build a clearer picture of the manager s depth of analysis and objectivity. This exposed weaknesses in the application of the process and behavioural flaws. Case study 2 We discussed a small UK-based technology company, CSR, with a manager. During this interview the manager stated that his competitive advantage in assessing this company was largely based on the market s preoccupation with short-term earnings momentum when valuing IT hardware stocks and his discipline in exploiting the mispricing that could occur as a result. He was clear that he had no better understanding of the technologies applied by this company than the market. He comprehensively illustrated both the case for investment in the business and the case for the shares to underperform thereby demonstrating balance and emotional detachment from the investment decision, something we believe helps to avoid behavioural errors. Equity investing: Insights into a better portfolio 37

38 02 Manager selection Implications for manager research businesses For a detailed discussion on individual investments to take place it is necessary to have some current knowledge of the investment. Annual reports and other regulatory filings are readily available and provide excellent research material. There is also a wealth of accounting and news data available through sources such as Bloomberg or Reuters. Undoubtedly the greatest challenge to the manager researcher is setting aside the time needed to prepare for these discussions. Thorough preparation for a discussion with a manager, which results in questions targeted to produce useful insights and evidence of skill and behavioural characteristics, can take many hours. However, it is this that separates those organisations who prioritise the quality of their manager research from those for whom manager research is just an ancillary service to support a broader consulting relationship. Among the many parallels that exist between investment research and investment manager research is the fact that both the portfolio manager and the manager researcher are making judgments based on incomplete and imperfect information. Neither knows anything with certainty. In order to improve the probability of forming a correct judgment a good manager researcher or asset manager will look for opportunities to gain additional insight. In the case of the manager researcher this often involves observing aspects of the process in action through sitting in on internal meetings or even external research meetings between the manager and the management of existing or prospective investments. Such opportunities can be invaluable. But again, to be effective this requires the manager researcher taking responsibility for acquiring enough knowledge of the investment manager s process and investments to appreciate the often subtle distinctions between a strategy that can credibly sustain alpha generation from one that is destined to fail. Figure 05. Cumulative outperformance of the Towers Watson Global Equity Model Portfolio 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% This chart shows the cumulative excess returns achieved by the Towers Watson Global Equity Model Portfolio since its inception net of all fees and expenses. Source: Towers Watson In order to improve the probability of forming a correct judgment a good manager researcher or asset manager will look for opportunities to gain additional insight. 38 towerswatson.com

39 Explicit assessment of the investment skill of an asset manager is complex and challenging. It involves confirming the validity of the manager s investment philosophy and defining in detail the process by which the manager seeks to capitalise on alpha opportunities. The primary sources of alpha generation must be understood and a comprehensive framework for assessing skill in these areas established. The researcher must have the ability to determine some of the investment drivers and key issues for reaching an investment decision on selected investments based on publicly available information. Time must be made available to do the necessary preparation prior to meetings and evidence of skill, behavioural weaknesses and other issues must be interpreted and documented. The challenges in doing this represent a material cost to the manager research organisation and are no guarantee of success. However, they may provide the edge that prevents forming the wrong judgment about whether an asset manager is an alpha generator or more likely, an alpha pretender. 7 Explicit assessment of the investment skill of an asset manager is complex and challenging. References 1 Stewart, S D. Neumann, J J. Knittel, C R. and Heilser, J. Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors. Financial Analysts Journal, Vol. 65, No. 6 (2009): Based on a hypothesis test (one tail t distribution analysis at 95% confidence and IR=0.5), one would need more than 13 years of yearly observations. t stat = (X 0)/(X/0.5/sqrt(n)) should be bigger than t(0.05, n-1) to accept the hypothesis that annual outperformance X is positive. 3 Keynes, J M. The General Theory of Employment Interest and Money, Replacing managers for performance reasons. Towers Watson Limited, Goyal, A. and Wahal, S. The Selection and Termination of Investment Management Firms by Plan Sponsors, Minahan, J R. The Role of Investment Philosophy in Evaluating Investment Managers. The Journal of Investing, Summer The Search for Alpha. Watson Wyatt Limited, January Equity investing: Insights into a better portfolio 39

40 02 Manager selection Do not hire managers for past performance More evidence of why this approach can lose value When it comes to investment managers, the natural assumption to make is that those who outperform over the long term are skilled. That may be the natural assumption to make, but it is wrong. Here, we show that the vast majority of managers with very strong past performance lack the skill to outperform reliably in the future. In fact, only about 20% of the managers with very strong past performance are skilled investors. This finding raises the question: why do so many investors rely on past performance, when it contains so little information? We will give more evidence of how value can be lost when investment managers are hired for their past performance. 1 Specifically, we observe that most investment managers with good past performance lack the skill to outperform reliably in the future. We also consider the behavioural biases that tend to make investors assume that outperformance is a more likely indicator of skill than it actually is. Our reasons for saying that most managers with very strong performance are unskilled To show how we arrived at this view, consider the example of US equity managers. 2 By most accounts, there are thousands of different US equity portfolios being managed today. 3 (We have 3,819 US equity products in our database alone.) To keep the maths simple, we will assume that there are 4,000 of these products. Furthermore, in a recent study, Barras et al (2010) 4 estimate the proportion of managers that add value, destroy value and perform like the benchmark over the long term. We call these managers skilled, bad and mediocre, respectively. Using the proportions stated in this study, we assign relative weightings of 10%, 20% and 70% to these three manager types. 40 towerswatson.com

41 Knowing the descriptions of these three types of managers, we then make some assumptions about how they should perform in the future. First, we assume that all manager types have excess returns that follow a standard distribution, with a tracking error of 5% a year. 5 We also expect that the skilled, mediocre and bad managers will generate annual excess returns of 2%, 0% and 2%, respectively, if held indefinitely. With this information, we can calculate the probability that these manager types generate good performance over a three-year period where good performance is an excess return above 2% a year. 6 We depict these probabilities for skilled, mediocre and bad managers in Figure 01. As can be seen, skilled managers have a clear advantage. They are almost twice as likely to generate good performance as mediocre managers, and four times as likely to do so as bad managers. For that reason, we can understand why some investors might initially think that most good performance should come from skilled managers. Unfortunately, though, these investors are making a common error: they are not accounting for the relative prevalence of the three types of manager. Rather, they implicitly assume that all three types of manager are as common as each other. As we showed before, however, this is not the case. The relative prevalence of skilled, mediocre and bad managers is 10%, 70% and 20%, respectively. We can therefore combine these values with those from Figure 01 to determine the expected number of managers with good past performance. We depict these expectations in Figure 02. Of those managers with good performance (in plum), 190 are skilled, 634 are mediocre and 62 are bad. Despite skilled managers being far more likely to outperform than any other manager, they represent only 190 (or 21%) of the 886 managers with good past performance. Put another way, if you only ever hire managers with good past performance, only 21% of your candidate managers will be skilled. Worse still, you would also overlook the majority of skilled managers. (After all, 210 of the 400 skilled managers would not have good past performance.) At this point, you may be thinking that much of this discussion is academic. You may think All I need to do is to ensure that I don t hire managers for performance reasons. If only it were so simple. Unfortunately, two negative effects often hinder investors that want Figure 01. The probability of generating good performance by manager type 50% 40% 30% 20% 10% 0% Figure 02. The expected number of performers by manager type 3,000 2,000 1,000 0 to behave in this way. Skilled Mediocre Bad Skilled Mediocre Bad Good performers Not good performers First, past performance can subtly influence an investor s perception of a manager. After all, managers might make better presentations after good performance (as they have more confidence and can use better examples). Likewise, all managers have some weaknesses in their process, but these weaknesses usually come under more focus when they have underperformed. Second, as investment firms seek higher profits, they will market the products that they think will win the most business (that is, the good performers). As such, investors (and investment consultants) will tend to see more marketing material on good performers than would be ideal. The confluence of these two effects should lead investors to be highly mindful of the unwanted influence that a manager s past performance can have on them. Equity investing: Insights into a better portfolio 41

42 02 Manager selection Why might investors assume that outperformance is a more likely indicator of skill than it is in reality? As we saw in Figure 01, some investors might initially think that most good performance should come from skilled managers. Instead, we showed that this is untrue, as there are more mediocre and bad managers than good managers. 7 To psychologists, this situation is an example of representative or base rate bias. But why does this bias occur? According to the experts in this field, people rely on a limited number of heuristic principles, which reduce the complex tasks of assessing probabilities and predicting values to simpler judgemental operations. In general, these heuristics are quite useful, but sometimes they lead to severe and systematic errors. 8 Consider another popular example of base rate bias, this time from Michael Pompien. His example involves a shy man, called Simon. Pompien asks for opinions on whether Simon is more likely to drive a BMW or be a stamp collector. People generally respond that Simon s shyness is more representative of being a stamp collector than a BMW driver. What they neglect to consider, though, is that there are far more BMW drivers than stamp collectors in the world, and so Simon is much more likely to drive a BMW....investors should downplay the importance of past performance and focus on reliable drivers of future excess returns. 42 towerswatson.com

43 Quantitative investing Will quants strike back? Quantitative equity managers ( quants ) have experienced a roller-coaster ride in the past 10 years. Throughout the middle of the last decade, life was good for quants: performance was strong, asset inflows were significant, and even fundamental managers were embracing the merits of quantitative tools in screening and portfolio construction. Today, however, investors often exclude quants from their agenda. Equity investing: Insights into a better portfolio 43

44 02 Manager selection What went wrong? How has the industry reacted? What is Towers Watson s current view on this group of asset managers? Here, we answer these questions and suggest what opportunities may lie ahead for quantitative approaches. Quants on a roller-coaster Quants, who use systematic factor-based models to analyse and invest using widely available data, have a long history in equity management. Financial market historians ascribe the beginning of quantitative investment strategies to Harry Markowitz s seminal work on portfolio theory in From a few early adopters, quants slowly found their place as providers of niche investment approaches alongside traditional fundamental managers. Much of that popularity stems from the growing support of finance academics. 2 The early 2000s changed the scene. Having gone through the dot-com bubble unscathed, quant strategies gained widespread legitimacy, becoming popular with investors and attracting dramatic growth in assets on the back of strong returns. 3 Strategies employing leverage were particularly successful. Many fundamental managers adapted their processes to make greater use of quantitative insights. The end for traditional fundamental approaches seemed nigh. But the history of financial markets is replete with humbled investors and the extraordinary success enjoyed by quantitative strategies proved to be short-lived. Many quantitative managers have performed poorly (see Figure 01), and just as strong performance led to strong inflows, the opposite has come to pass. Quantitative investing is, for many today, out of fashion. Figure 01. Relative rolling five-year performance of a representative group of large active quants 4 Return (US$ per annum) 6% 4% 2% 0% -2% -4% -6% towerswatson.com

45 What happened? Too many assets In our January 2008 article, Quant management at an inflection point, we painted a cautious view on quants. Our concern was primarily driven by the significant increase in assets, often leveraged and managed using quantitative strategies. We felt that structurally low barriers to entry and prolonged favourable market conditions had encouraged excessive asset gathering (see Figure 02) in broadly similar strategies, thereby reducing the attractiveness of the opportunity set. Extreme market events, such as the quant crunch during the summer of 2007, were caused by crowding in other words, too many assets chasing the same return factors. Quantitative approaches, relying largely on historical information to forecast risk and return, were not well-suited to capture the systemic risks created by these crowded trades. For example, before the financial crisis, few quantitative managers used valuation spreads to assess the attractiveness of value. Even fewer had developed indicators to monitor crowdedness. The trend is not always a quant s friend The risk-on/risk-off macro-led market environment seen over the past few years has been challenging for active equity strategies, whether quantitative or fundamental. Two investment styles in particular faced headwinds in this environment: value and momentum. We discussed our views on value in a recent article. 6 Momentum is a trend-based investment style that struggles at major market inflection points (as, by definition, it lags behind changes in market leadership). Many quants use momentum to add diversification to their often value-biased approaches. As the two styles are expected to be complementary, the theory is that a combined approach should generate smoother returns. This had been the case for many years. However, when both styles underperform there are few places for a quant to hide, particularly if the strategy is expected to add value over the short to medium term. As Figure 03 suggests, it is no coincidence that recent style headwinds in value and momentum coincided with negative performance for quantitative managers. Figure 02. Increase in quantitatively-managed assets 5 Assets (US$ billion) Source: GMO, Towers Watson 20% 15% 10% 5% 0% -5% -10% Figure 03. Relative rolling five-year performance of value and momentum 7 Return (US$ per annum) Momentum Value Source: Style Research Limited, Towers Watson...it is no coincidence that recent style headwinds in value and momentum coincided with negative performance for quantitative managers. Equity investing: Insights into a better portfolio 45

46 02 Manager selection All change please Over the past five years, quants have had to face a challenging environment. Many quantitative managers decided they had to change their approaches significantly, in order to maintain a competitive edge. By and large, these efforts have focused on three areas: uniqueness of insights, style-timing and judgemental input. Unique insights. To avoid the issues resulting from the crowding of factors, quantitative managers have worked hard to identify unique insights. Some managers sought newer, differentiated data sources or worked to build proprietary signals, leveraging less exploited relationships between data and expected returns. Style-timing. This has been at the top of the research agenda. Quants have increasingly attempted to make use of dynamic risk/return frameworks that adapt to changes in equity market leadership. Judgemental input. Some managers have decided to broaden their risk/return framework by adding macro-based signals or to rely more on fundamental or thematic judgement to compensate for the limitations of their quantitative models. What we look for in quants Not all innovation has resulted in improvements. Whilst still relying on traditional factors, quantitative equity strategies have become increasingly heterogeneous and complicated. This has raised the bar for asset owners and consultants when seeking to understand and assess these strategies. However, we believe there are a few quantitative managers that are ahead of their competitors and can demonstrate credible differentiation in their approach. Some of the key things we look for are: Introspection The best quant managers are highly reflective and well aware of the natural shortcomings in quantitative approaches. They know that quantitative tools may introduce discipline but are not inherently better than traditional, subjective methods. These managers are more likely to foresee problems rather than react to events. Pragmatic market awareness It is important that managers complement robust historical studies with a pragmatic and intuitive understanding of markets. For example, we think...quantitative equity strategies have become increasingly heterogeneous and complicated. that some style-timing indicators may have long-term signalling power. However, many managers are required to deliver alpha over the shorter term, and style inflection points are very difficult to predict with accuracy. Back-tests of style rotation indicators are, by definition, period-specific and we have observed a number of these processes struggle when used in real-life scenarios. Factor differentiation We are cautious of managers claiming an edge through the exploitation of unique factors. Such factors are, in fact, rarely unique. We see similar insights spreading rapidly across the quantitative investment community, inevitably impairing their effectiveness. In order to prolong its competitive advantage, a manager may become more secretive. But this reduces transparency and can make it more difficult to confirm competitive advantage. Data mining can also be an issue as ever-growing swathes of data series are scrutinised. Finally, even when we see more differentiated factors, they frequently do not account for a significant part of the quantitative model s overall risk budget. Low assets Everything else being equal, a modest level of assets under management is an advantage. Our view remains that it is easier to deliver alpha with total assets of US$1 billion than it is with, say, US$20 billion. This is particularly true for higher portfolio turnover approaches which use factors with a short-time horizon for potential added value. Suitable fees Fees for quants are often too high for the likely level of value added. Managers often have over-optimistic assumptions about the future information ratio (the ratio of relative return per unit of relative risk taken) of their strategies. Some managers also develop products with very low active risk in order to optimise gross information ratios of the strategy, effectively ignoring the real-world drag from fees paid by clients. 46 towerswatson.com

47 The rise of smart beta We do not subscribe to the belief that traditional quantitative factors have been permanently arbitraged away. We expect the well-documented behavioural phenomena behind these factors, such as the premium associated with basic valuation ratios, to recur over the long term and provide opportunities for patient investors. Market innovation is making quantitative investing more commoditised. This may present challenges for some types of active manager. However, for the asset owners, this trend is good news. Systematic equity exposures can increasingly be accessed through cost-effective, transparent and easily-implementable investment strategies, leading to improvements in overall investment efficiency. We have long been advocates of such solutions which we call smart beta that bridge the gap between passive and traditional active approaches. Index providers and passive managers have so far been at the forefront of the smart beta trend. There is now a widening range of indices and products that offer alternatives to the default market capitalisation-weighted index. Of course, some of the caveats that apply to quants also apply to systematic smart beta approaches. Indeed we believe that traditional quantitative managers have a role to play within smart beta, given their extensive experience of the practicalities of quantitative investing....we believe that quantitative investing can still play a useful, and expanded, role in portfolios via greater use of smart beta strategies. In summary Following disappointing performance from some products, traditional active quantitative equity investing is now far less popular. We have a positive view of some strategies, but remain cautious on this group as a whole. Despite efforts by managers to differentiate themselves, innovation rarely remains unique for long and process enhancements often lead to greater complexity. Nonetheless, we believe that quantitative investing can still play a useful, and expanded role in portfolios via greater use of smart beta strategies. Asset owners can use systematic strategies to target style exposures inexpensively and in a way that is consistent with their beliefs or portfolio construction needs. To achieve this, it may not be necessary for quantitative approaches to use unique inputs or to be very complicated if they are well-grounded and available at reasonable fees. A smarter quant could be a simpler quant. References 1 Markowitz, H. Portfolio selection. The Journal of Finance, March For example: Fama, E. and French, K. The cross-section of expected stock returns. The Journal of Finance, June 1992; or Jegadeesh, N. and Titman, S. Returns to buying winners and selling losers: Implications for stock market efficiency. The Journal of Finance, March For example, Casey Quirk & Associates LLC. The geeks shall inherit the Earth?, Average relative returns of representative active global or international equity strategies from 10 large quantitative managers. Manager selection based on assets managed in active quantitative-only strategies. Performance is relative to stated strategy benchmark, gross of fees. 5 US$ value of coincident holdings, as taken from 13F filings in US, of the largest eight quantitative-only investment managers. 6 Value investing an old idea, but probably a good one. Towers Watson Limited, January Simulated performance of selected strategies; momentum: highest quintile by 12 months price momentum; value: highest quintile by earnings yield. Universe: Largest 2500 global companies in global universe, market capitalisation weighted, quarterly rebalance. Equity investing: Insights into a better portfolio 47

48 02 Manager selection Concentrated equity products Why we prefer them to diversified products For a typical investor s portfolio, adding skilled active management increases expected return without much change in total risk. We therefore encourage equity investors to seek products with higher expected returns. That means concentrated rather than diversified products. Investor preferences drive the choice of concentrated or diversified equity products. Most investors want to improve the return efficiency of their entire portfolio. We call this a portfolio-level preference. That requires them to consider the contribution of asset allocation and active managers. We generally find that using skilled active managers helps to improve overall investment efficiency. That is because expected active returns add to expected asset returns, whilst overall risk barely changes with the introduction of active risk. We therefore expect active management to have positive marginal impact on overall risk-adjusted return. 1 All other things being equal, we expect investors with these portfolio-level preferences to favour products with higher levels of expected excess return. They should, therefore, favour concentrated products to diversified products. This is our main point in this article. Some investors have a narrower focus, though. Their focus is at the product level rather than at the total portfolio level. They just want each active manager to generate its excess returns efficiently, with the best information ratio. This goal also minimises the chance that any one manager will underperform. 2 By doing so, these investors underplay the contribution of asset risk to total risk. 48 towerswatson.com

49 The assumptions of Grinold and Kahn (2000) 3 show that a manager can increase its information ratio by making more decisions that are independent. That would imply a higher information ratio for diversified products, as investment managers make more decisions in them than in concentrated products. In other words, diversified products are more suitable to investors with product-level preferences. Whilst we applaud the ingenuity of Grinold and Kahn s thinking, we doubt some of their simplifying assumptions. As we show later, real-world evidence suggests that these simplifying assumptions are unrealistic and lead to an overly favourable view of diversified portfolios relative to their concentrated counterparts. We now expand upon these points, by: Using a simple example to show how investment preferences can drive the choice of concentrated or diversified equity products Explaining our preference for concentrated portfolios in other ways Asking whether diversified products have better information ratios than concentrated products Outlining why some investors with product-level preferences may fare better with passive management An example of how investor preferences can drive the choice of concentrated or diversified equity products Imagine two investors, Don and Carl, who only invest in equities. Their portfolios are almost the same. They split their assets equally between the same two skilled managers, ABC Investors and DEF Partners. The only difference is that Don uses the diversified products of these managers, whilst Carl uses their concentrated products. Each product has the same benchmark, which reflects the broad equity market. The correlation between the excess returns of ABC and DEF is 0.2, be that for diversified or concentrated products. In keeping with our previous statements, we expect the concentrated products to have double the excess returns and triple the tracking error compared to the diversified products. 4 Given these values, an investor with product-level preferences would favour Don s portfolio of diversified products, with its better information ratio (of 0.43 versus 0.29). We now consider the total picture. We assume that equities return 5% a year on average, with a variability of 15% a year and with no correlation to the excess returns of the managers. Equity investing: Insights into a better portfolio 49

50 02 Manager selection Figure 01. The excess returns of diversified and concentrated products Expected excess return Tracking error Information ratio at the product level Don s diversified products 1% pa 3% pa Carl s concentrated products 2% pa 9% pa Information ratio at the portfolio level Figure 02. The overall returns of diversified and concentrated products Expected return Risk Don s diversified products 6% pa 15.2% pa0.40 Carl s concentrated products 7% pa 16.5% pa0.42 Ratio of expected return to risk at the portfolio level Figure 02 shows the impact on the overall ratio between expected returns and risk, a measure favoured by those with portfolio-level investment preferences. Using this measure, we expect Carl s concentrated products to beat Don s diversified products. The higher excess return and tracking error of the active products increases expected total return far more than it increases total risk. That is particularly true for the concentrated products. This is the main reason why we generally advise most investors to use concentrated rather than diversified equity products. Other reasons for preferring concentrated portfolios Our other main reason relies less on theory and more on common sense. If you think that an equity manager is skilled, then you should get its best ideas into your portfolio. In a world of uncertainty and imperfect managers, though, you do not just want your best manager to hold a one-stock portfolio. Instead, you should add some diversity. You should let your best manager put only its best ideas into your portfolio. Once the manager s conviction in its next-best stock idea falls, then you should move on to the second-best manager and get its top ideas. You should repeat this process until any more diversity unduly dilutes your expected outperformance. We can also make the same point in a similar way. Consider two equally weighted portfolios that both seek to beat the S&P 500 Index. The first portfolio is concentrated and holds 20 stocks, each at a 5% weighting. The other portfolio is diversified and holds 1% in each of 100 stocks. To hold these long positions, each portfolio has explicit or implicit underweight positions in the remaining stocks in the index. However, the size of the average active bet is about five times larger with the concentrated portfolio than with the diversified portfolio. Any stock selection edge from the concentrated manager will therefore be magnified relative to the outcome of the diversified manager. Contrary to the simplifying assumptions of Grinold and Kahn, we also find that many managers have particular expertise in certain pockets of the market. In these cases, the active bets of a concentrated approach would extract more value for the investor than those of a diversified approach. 5 For what it is worth, empirical work also suggests that managers with more concentrated stock decisions tend to outperform other types of managers. 6 Do diversified products have better standalone information ratios than concentrated products? In the summary, we said that Grinold and Kahn showed how to influence the best information ratio that a product can attain. We discuss these influencing factors below, comparing their values in concentrated and diversified products from the same manager. The skill of the forecaster. We expect no difference in skill between these concentrated and diversified products, as they share the same manager and benchmark. The number of independent forecasts made in the product. By design, the manager makes more independent forecasts in the diversified product. Theory also assumes that successive forecasts are subject to diminishing marginal returns. 50 towerswatson.com

51 The level of implementation efficiency in converting these forecasts into allocations within the product. Portfolio constraints play a large role here. Guidelines for managers, for example, often compel them to hold a given amount in certain parts of the investment universe. Traditional equity mandates also impose a long-only constraint to prevent negative allocations to stocks. 7 Theory suggests that this long-only constraint hinders implementation efficiency far more in products with higher tracking error. 8 For that reason, concentrated products tend to fare worse than diversified products in implementation efficiency. Perhaps for that reason, concentrated products often have fewer constraints than diversified products. Taking these points together and accepting the simplifying assumptions, the diversified product of a skilled manager would be expected to produce a higher information ratio than its concentrated counterpart, even though it should not outperform by as much. 9 Given our views in the previous section of this article, we do not accept all these simplifying assumptions. We therefore do not have strong views on whether diversified or concentrated products generate better standalone information ratios. Some investors with product-level preferences may perform better with passive management In The cost of trigger-happy investing, 10 we followed two investors in a typical equity product. We showed how the product only benefited the more disciplined investor of the two. The less disciplined investor, who could not tolerate prolonged underperformance, would have fared better with an index fund. We repeat this conclusion here, as it relates to a flaw in the reasoning of some investors when they argue for diversified products. According to these investors, they prefer diversified products because they lead to fewer instances of underperformance, and so to fewer occasions when they will fire the product. They then argue that they will not lose as much value from poor decisions but will still benefit from outperformance from most of their active products. Further reading Clarke, R. de Silva, H. and Thorley, S. Portfolio Constraints and the Fundamental Law of Active Management. Financial Analysts Journal, September/October 2002: Cremers, K J M. and Petajisto, A. How Active Is Your Fund Manager? A New Measure that Predicts Performance. The Review of Financial Studies, Track records Luck or judgement? Introducing hit rates and win loss ratios. Inalytics Limited. Scherer, B. and Xu, X. The Impact of Constraints on Value-Added. Journal of Portfolio Management, Summer Concentrated Portfolios: An Examination of their Characteristics and Effectiveness. The Brandes Institute, Remapping our investment world. Watson Wyatt, References 1 This article concerns equity portfolios but many of the principles also apply to other asset classes, even though the definitions of concentrated and diversified may differ. 2 When combined with a manager s commercial goals, these conclusions may help to explain why managers often target the best information ratio for their product. After all, an investment manager usually gains most commercial benefit if it retains its mandate with the client. As it can improve its odds of retention by trying to minimise its odds of underperformance, it does so by targeting the maximum information ratio for its product. Of course, this action makes commercial sense for the manager, but does not necessarily benefit the client. 3 Grinold, R C. and Khan, R N. Active Portfolio Management. McGraw-Hill Professional, We base these assumptions on performance after fees. We recognise, however, that the fees for concentrated products typically exceed those of diversified products in absolute terms, but not in risk-adjusted terms. 5 The article from Inalytics also considers this dynamic. Put briefly, it shows that managers collectively tend to win more than they lose in overweight positions. However, they lose more than they win in unintended short positions. 6 See Cremers and Petajisto (2009) for further details. Seemingly running counter to these views, other studies have shown that the average concentrated manager does not outperform the average diversified manager, both before and after a risk adjustment. One such example is the paper from The Brandes Institute. To us, these findings are reasonable but potentially misleading, as we condition our preference for concentrated managers on them being skilled, not average. 7 Investors can improve the information ratios of many skilled managers, however, by relaxing the constraint against holding a negative weight in a stock. That said, fees are often higher and these long/short portfolios tend to suit the investment approach of only a subset of fundamental managers. 8 For further details, see Clarke et al (2002), and Scherer and Xu (2007). 9 See Kroll, B. Reach for more excess return but don t hurt yourself. Part II: The paradox of portfolio concentration are your manager s best ideas good enough? JP Morgan Asset Management, 2004, for further details. 10 The cost of trigger-happy investing. Towers Watson Limited, Given the conclusions of our other article, this double negative argument will harm the investor. Investors that prefer diversified products for this reason should improve their likely outcomes and invest in an index fund. Equity investing: Insights into a better portfolio 51

52 02 Manager selection Low volatility equity From smart idea to smart execution Low volatility equity strategies have gained a lot of attention in the last two years, with proponents claiming they can deliver market level returns for below market level risk. We have seen significant interest from our clients worldwide and the volume of new product launches from asset managers has been remarkable. The low volatility idea has merits Towers Watson s Thinking Ahead Group was one of the first to advocate inexpensive, transparent, systematic strategies ( smart beta ) as an attractive alternative to some forms of traditional active management. For example, our institutional investment clients have allocated over US$18 billion to smart beta solutions. In addition, our active equity manager research team has long been a proponent of skilled managers with defensive, quality-oriented approaches particularly during periods of high market uncertainty. Combining the broad smart beta initiative and defensive equity investing brings us to smart beta low volatility equity strategies. The potential merits of the low volatility thesis are quite compelling: it is supported by long-term empirical evidence with plausible intuitive rationales; there is the prospect of reduced volatility, reduced absolute drawdowns and improved reward per unit of risk; it has the potential for use in de-risking programmes; and, finally low volatility strategies can be inexpensive, transparent and widely available. That said, plausible arguments also exist that a large part of the low volatility observation can be explained by existing investment return drivers which have long been recognised such as market beta, value, country or sector effects. 52 towerswatson.com

53 Potential pitfalls While the low volatility concept is worth investigating, there are potential hazards along the path from the initial idea to final implementation. There is a very wide range of strategies to consider and smart beta investments are a new avenue for many investors. Furthermore, the effect of impressive results from the strategy tends to raise expectations, rather than raise caution which may be a more appropriate reaction. We believe it is essential to navigate the potential pitfalls, which we highlight here. Realistic expectations Empirical evidence suggests that there is a trade-off between return and risk, but that this relationship may be flatter than traditional market theory suggests. If so, a low volatility equity portfolio may have a higher risk-adjusted return than the market as the reduction in risk is achieved with only a moderate sacrifice of return. Note that we still expect a somewhat lower than market return from (unlevered, long-only) low volatility equity strategies over the long term. Having an expectation of significant risk reduction without any sacrifice of long-term return is, in our view, counterintuitive and based on an overemphasis on period-specific historical backtests. Hence, we are cautious of the statement used in marketing presentations: market level returns for below market level risk. Figure 01. Success or failure? Empirical evidence suggests that there is a trade-off between return and risk, but that this relationship may be flatter than traditional market theory suggests. Measurement should not be an afterthought It is important for investors to determine, in advance, their objectives from an investment in a low volatility equity strategy. Different approaches to measurement may determine whether such an investment is considered a success or a failure, as demonstrated in Figure 01. Current market conditions The case we most typically hear supporting low volatility equity is a strategic one based on long-term historical evidence. However, we believe long-term past factor performance should only be a tentative guide to the future. As demand for low volatility equity strategies increases then a portfolio of low volatility stocks becomes more expensive thus reducing future returns, all else equal. Our analysis of current market conditions considers the valuation of a global low volatility strategy from several angles. Recently we have observed that, while the strategy looks reasonable from an absolute valuation perspective, the relative valuation appears stretched compared to historical levels. Investor A The market returns 14% per annum with 20% volatility Investor A notes the lower achieved volatility but is more focused on the (non risk-adjusted) relative return of -2% per annum. Investor A is unhappy Investor B Low volatility strategy (beta 0.8) 5 years Low volatility strategy returns 12% per annum with 15% volatility Cash returns 2% per annum Investor B looks at the risk-adjusted return of the low volatility strategy versus the market. Against a composite 75% market, 25% cash benchmark he sees outperformance of 1% per annum. 1 Investor B is happy Equity investing: Insights into a better portfolio 53

54 02 Manager selection Figure 02. Number of low volatility products on evestment database over time Source: evestment Alliance Methodology: Analysis based on searching for equity products on the evestment Alliance database containing the terms low volatility or defensive. Growth is understated as we are aware of products which are not yet on the database. Selecting the right product Perhaps the greatest challenge to an investor that wants to invest in a low volatility strategy is the overwhelming choice available. We have observed huge growth in low volatility equity products over time as shown in Figure 02. We believe there is a devil in the detail challenge when evaluating low volatility equity strategies. One key differentiating factor between approaches is the breadth of methodology. We are cautious of processes that focus on low historical price volatility to select securities. In some global equity simulations of this approach, we observed a large allocation to the financial sector prior to the global financial crisis. This would probably surprise investors thinking they were buying a safer portfolio of equities. This example demonstrates that low historical stock price volatility is not a watertight guide to the future resilience of a business. The criterion for a stock to have low historical price volatility is simply that there were few sudden changes in the balance between buyers and sellers over the particular period in question. We are also concerned that undifferentiated low volatility strategies may suffer from poor liquidity owing to the crowding of similar approaches buying the same universe of stocks (as experienced by quantitatively driven approaches in 2007). Products in this space differ considerably in terms of their complexity. Examples include embedded quantitative alpha models, fundamental risk models, statistically-based principal component models, implied volatility models and various optimisation techniques. The more complex the process, the less transparent, and the more effort is required to evaluate the relative expertise of the manager. The existence of more moving parts within a process often leads to higher turnover and potentially higher transaction costs. Furthermore, greater complexity usually results in greater management fees. We would argue that fees in this area should be low given the moderate running costs, high capacity, and the intense level of market competition. Summary We advocate smart beta investments as a new avenue for many investors. In our view, low volatility equity can be smart, but only by avoiding the potential pitfalls. References 1 In the example given, Investor B could also have used alternative risk-adjusted performance measures such as Jensen s alpha. This article is based on a Towers Watson article first published in Investment Pensions Europe (IPE) in November towerswatson.com

55 Sustainability in investment research A pragmatic approach Capital markets, economic linkages and political realities are likely to be starkly different in 10 to 20 years from now. Several interconnected converging mega-trends will lead to transformational change in coming decades and impact directly on long-term economic growth prospects. Adverse demography, economic imbalances and degradation of natural capital will all shape the investment landscape as will changing roles and the influence of business, government and innovation. Whilst some of these trends are reasonably well understood, others, such as environmental and social trends, are more complex and difficult to predict. Given these prospects we believe that prudent long-term investors need to consider how their investments might be affected over time. This goes hand-in-hand with the growing focus on long-term investment and responsible stewardship of capital. In this context we are incorporating sustainability considerations into our investment research, both from an asset class and investment manager perspective. Within our manager research process we consider the relevance of longer-term sustainability trends on differing investment styles, philosophies and portfolios. Active equity strategies with long time horizons, of five to ten years for example, will undoubtedly be more sensitive to sustainability factors than trading style strategies which have a much higher portfolio turnover. By their very nature, passive strategies will feel the full force of market wide impacts such as changing demographics and degradation of natural capital. Strategies with high exposure to resource intense sectors, such as mining, cement, oil and gas will be affected by carbon pricing, greater legislation and liabilities from environmental damage. Similarly portfolios investing in companies with strong consumer brands could be negatively affected by poor labour standards in supply chains or fast-food companies by efforts to curb the rise of obesity. Using a propriety analytical tool we assess the sustainability risk profile of equity portfolios drawing on stock specific performance data supplied by a third party. We can identify where the most significant sustainability risks lie within a portfolio from a regional, sector and stock perspective. Alongside more traditional risk attribution this analysis provides another lens through which to assess portfolios. In our discussions with investment managers we explore how they identify, assess and act on the sustainability risks inherent in their portfolio. As we noted earlier, the degree to which these risks are relevant to any given strategy is a function of its time horizon, style and particular exposures. Where sustainability trends could realistically impact asset prices over the possible holding period we expect managers to try and reflect this in their investment thesis, financial models and/or ownership activities. Clear thinking on sustainability risks may also influence a managers portfolio construction and risk assessment processes. Predicting the future is not a precise science and the impact of sustainability trends is highly uncertain. With this in mind the use of scenarios and stress testing can be useful tools to explore how portfolios will respond to changing parameters. Identifying and collating key data points will be critical in understanding how and when dynamics are shifting. Given future uncertainty and pace of change the need for diversity within and/or between portfolios becomes even more important. We re in the early stages of understanding the impact of sustainability trends on investment risk and return and we encourage and welcome an open debate with asset owners and managers around how we can advance best practice. One thing that we do know however is that it is important to start the research and analysis now to reduce the risk of being caught out in the future. Equity investing: Insights into a better portfolio 55

56 02 Manager selection What to look for in a passive manager Passive management, or indexation, is often seen as a commodity product, where choices should be made on price alone. We do not believe this to be true. Here, we explore points of differentiation between passive equity managers and aims to illustrate why we believe rigorous qualitative research can lead to better outcomes. In passive equity management, the primary objective is to track an index of stocks, whether it is a bulk beta or a smart beta index. It is often used in a portfolio to deliver broad, low-cost equity exposure and, as such, it can be easy to focus on headline costs. However, doing passive management well is more complicated than many people realise and we believe it is well worth spending time researching the nuances of various products and the methodologies being applied. Poor passive management can, for example, lead to higher transactions costs and/or unexpected performance deviations from the chosen benchmark. Good passive management involves focusing on the detail. In Figure 01 we have set out what we believe to be the key criteria for passive managers and expand on each of these criteria below. A common theme that runs across a number of these criteria, and contrasts with active management, is the advantage that accrues from size. Size is no guarantee of quality in an index manager, but it often helps. Indexation, more than any other form of fund management, is a low margin, high capacity product. Competition between managers and the perception of indexation as a commodity means that managers rarely see the kind of profit margins that are seen in other areas of fund management. Therefore, in many of the areas that we highlight, there are advantages of scale, both at the manager and the product level. Figure 01. Key criteria for passive managers Investment professionals Broad, deep, experienced team Philosophy and insight generation Methods to add value within acceptable risk parameters Portfolio management High quality systems Efficiency of trading Securities lending Firm and team stability Size of the indexation business Opportunity set Size of individual index tracking funds Appropriate fund structures Alignment Low fees and costs A range of ancillary services Strong client service 56 towerswatson.com

57 Investment professionals Indexation, unlike other areas of fund management, does not tend to attract star portfolio managers. However, index tracking requires a specific skill set, so a dedicated and high-quality team can make a lot of difference to the strength of the offering. Experience is an important characteristic, as well as a good understanding of both quantitative risk systems (their strengths and limitations) and more lateral risk metrics. Depth of team is also important, to ensure a comfortable level of coverage for each portfolio manager. In our opinion, portfolio managers should not have too many different accounts to manage and should also have an understanding of different types of client accounts. Philosophy and insight generation While the primary function of an index manager should always be to provide returns that are close to those of an index, the art and science of indexation is to hold a range of securities that will track the performance of the underlying index closely, without incurring a disproportionate cost in accessing and holding these securities. Techniques that a manager will employ will vary depending on the index being tracked, the size of the product and the manager s investment philosophy. A large pool of assets generally makes it more cost-effective to hold a greater proportion of the index constituents a manager may be able to offer full replication, where every stock in the index is held. A pool that is smaller, or is tracking an index of stocks that are more expensive to buy and sell, may be run on an optimised basis, where the manager aims to generate the returns of the index by holding a representative sample of stocks. Any kind of sampling is likely to result in higher tracking error or tracking difference than full replication. In addition, managers may seek to add small amounts of value to offset cost within acceptable risk parameters, for example by timing trading around index changes. The best managers will balance total returns after fees against minimisation of tracking error (or tracking difference)....managers may seek to add small amounts of value to offset cost within acceptable risk parameters, for example by timing trading around index changes. Equity investing: Insights into a better portfolio 57

58 02 Manager selection Portfolio management High quality systems The nature of indexation management means there is a strong focus on cost and risk. The best managers have systems that allow them to see their portfolios easily, understand what the key risks are and transact efficiently within their defined parameters. Pre- and post-trade compliance checks that are built into the portfolio and order management systems are another important risk mitigation feature. A high level of commitment to buying, building and maintaining these systems is a differentiating factor for the leading firms. While a high specification and easy to use system may seem nice-to-have rather than essential, we believe that these tools materially reduce risk of human error. Efficiency of trading Almost no index that is tracked, be it in equities, bonds or alternatives, takes account of transaction costs. Every penny that is spent on transactions, administrative costs, fees and taxes represents a negative tracking difference. All managers should be aware of trading costs, but for indexation managers that often hold large numbers of securities in relatively small proportions and have no alpha in which to hide costs, reducing these is a crucial efficiency. Again, scale can help here, as large managers are likely to have more money moving around in order to match buyers and sellers of stock, and are able to negotiate favourable terms with brokers. Some managers have periodic days where they try to encourage all clients to trade, so as to maximise crossing opportunities. As technology and trading venues continue to broaden and expand with the growth of direct market access, algorithmic trading and dark pools, we would expect to see the best indexation managers leading efforts to drive trading cost efficiencies for their clients. Securities lending Securities lending within the portfolio is an additional method that a manager may use to add return to the portfolio, but it is not without risks. These risks were graphically illustrated in 2008 when many funds had problems with their stock lending programs, mostly where cash collateral had been reinvested in assets that became illiquid. This caused underperformance and, in a number of cases, withdrawal restrictions. Securities lending programmes in particular should be reviewed to ensure that investors are happy with the risks they bring, looking for details such as: What limits there are on lending What collateral is taken and how it is held Whether indemnification is offered How revenues are split between the manager and the investors and whether that brings conflicts of interest The degree of oversight a manager retains of a program, if it is outsourced A good securities lending programme cannot make up for a poor manager and any such programme must be monitored. Done well, we believe it can be a beneficial addition to a good product. However, if investors are not comfortable with a manager s approach to securities lending, non-lending funds should be sought. Firm and team stability As we have noted, indexation, more than any other form of fund management, is a low margin, high capacity product. Where profit margins are low, gaining confidence that the team and systems will continue to be supported by the business for the long term is key. Firms with a large, established product base and a business structure where indexation products are important to the firm have an advantage here. As technology and trading venues continue to broaden and expand with the growth of direct market access, algorithmic trading and dark pools, we would expect to see the best indexation managers leading efforts to drive trading cost efficiencies for their clients. 58 towerswatson.com

59 Opportunity set Size of individual index tracking funds Within each index tracking fund, size is almost always a benefit. A large pool of assets can mean a manager can hold more stocks in the index, but it also gives a broader base over which to spread the (often largely fixed) administrative costs. When funds are very large they can also use this scale to create further efficiencies. A bigger fund is likely to have more buyers and sellers than a smaller one and so may offer opportunities for investors to trade at mid-price (through matching these buyers and sellers together). A large fund may also be able to use its scale to earn fees for sub-underwriting new stock issuance (which the fund has to buy as the stock enters the index), and to trade more opportunistically than a smaller fund might be able to. Appropriate fund structures to meet specific client needs There are clearly benefits in all types of fund management in offering the appropriate vehicle, but within passive management this can be one of the key differences between products. Different types of institutional investors in various markets have certain tax statuses. To invest in a vehicle that mimics their tax status or offers tax transparency can bring material benefits in areas such as withholding tax on equity dividends, for example. This is particularly important as a differentiator for certain categories of client, where the tax savings in an appropriate vehicle can swamp the manager fees a more expensive manager with appropriate vehicles may be a better choice than a cheaper manager with inappropriate fund structures. Alignment Low fees and costs As we have illustrated, headline fees do not tell the full story when assessing a passive product. Nonetheless, it is clear that one of the key benefits that passive management offers when compared to active management is its low cost. Understanding the total cost involved (fees and other costs) will factor into any assessment. It is important to note the details, such as cut off points on sliding fee scales and discounts offered for holding more than one index product with a manager: typically it is cheaper to find one manager than can offer multiple indexed products, as fees can be negotiated on total assets. A range of ancillary services and good client service Ancillary services are also an important part of the value proposition of indexation managers. The ability to monitor and rebalance a multi-asset class mandate against a benchmark, offer help in transitioning assets in and out of funds and offer currency hedging, are often key reasons for employing a passive manager in the first place. As a low-cost alternative to active management, it is important that the manager provides an efficient and helpful service and is available to support the client where necessary, providing representatives for meetings and general assistance. More broadly, alignment captures a manager s overall commitment to its client base. A manager may demonstrate positive alignment through its ownership structure or through fair distribution of securities lending revenue. Investors who prioritise environmental, social and governance factors may also evaluate managers on their alignment with these values, for example through established programmes of engagement with company management. Summary Passive management is a fast-growing sector in fund management, as many institutional investors focus on costs and efficiencies within their funds. It is often regarded as easy and argued that the selection decision should be based solely on fees. Here, we have demonstrated that while price is an important factor, there is a lot more to good passive management than low fees. We believe that broader qualitative due diligence, using the detailed criteria we have set out should be undertaken to ensure that appropriate managers are hired to meet an investor s needs, now and in the future. Equity investing: Insights into a better portfolio 59

60 Section three Manager monitoring 60 towerswatson.com

61 When constructing a portfolio, it is important to consider the level of governance resource that an investor can apply. The same is true when establishing the parameters for monitoring the implementation of decisions and evaluating their success (or otherwise). In this section, we ask if the decisions taken by investment committees alter their performance. Establishing an appropriate benchmark and time-frame to measure success is a necessary, but often misunderstood, first step. Evidence suggests that asset owners struggle to make timely hiring and firing decisions, so we address these here. Equity investing: Insights into a better portfolio 61

62 03 Manager monitoring Benchmarks matter Investors use benchmarks to: 1. Define an investment universe for their managers 2. Measure and evaluate performance It is therefore important for investors to review the benchmarks that are being used and ensure that they continue to be appropriate. Benchmarks are not static and often it is unclear what the differences are between similar-sounding benchmarks. The increase in absolute return mandates has made benchmarking decisions even harder. As an example, consider Asian equity indices. There are well over 100 different Asian equity indices available to investors covering a range of styles, sizes and regional variations. From a sample of 50 of these indices, the narrowest of these indices contains two countries, the broadest thirteen, and there are large differences in performance over prolonged periods of time. Given the considerable time and cost spent on monitoring, hiring and firing managers, it is important that the inputs to this process are as accurate as possible. Among other things, the choice of benchmark used can affect: Your opinion of whether or not a manager has demonstrated skill by outperforming the market Whether and how much you pay in performance fees to your managers The type and level of market exposures in your portfolio 62 towerswatson.com

63 What makes a good benchmark? An ideal benchmark index should represent the risk and return characteristics of the asset class and meet the criteria shown in Figure 01. Monitoring managers: Does outperforming a benchmark mean your active manager is skilful? Measuring performance against a market benchmark is a common way to assess whether a manager is able to add value by outperforming the market. The benchmark used for comparison needs to reflect the universe of investments from which the manager is choosing its holdings. Arguably, benchmarks should also reflect factors such as leverage, currency trades and style biases that affect performance but do not necessarily represent skill and should not be rewarded as such. As an example, consider the manager in Figure 02 who was appointed in January 1999 to manage a 100 million global equities portfolio. Performance was patchy for the first few years, but strong relative to the MSCI World Index in Then in 2009 they gave that all back and more, with a peak to trough fall of 6.8% in a year. Figure 02 does not actually show the performance of an active manager but shows the performance of the MSCI All Countries World Index against the MSCI World Index (the first includes emerging markets and the second does not). If this was the performance of a manager who was closely tracking the MSCI All Countries World Index but was measured against the MSCI World Index, that manager may have been terminated in 2006 for poor performance, or may have received a performance fee in 2009, when in fact neither of these actions is justified. Monitoring managers: have your managers styles drifted over time? Usually, an appropriate manager benchmark is considered as part of the initial manager selection process. However, a manager s approach can change gradually over time. The make up of a particular benchmark can also change over time, as securities and markets drop out of an index and new ones are added. Therefore, even if a manager s benchmark was the most appropriate choice when the manager was appointed, manager benchmarks should be reviewed to make sure they are still the right fit several years on. Figure 01. What makes a good benchmark? 1. Clarity 2. Completeness 3. Investability 4. Independent and regular data The index construction rules and constituents should be known and clearly defined. The index should have broad, diversified coverage of the securities available for investment in the asset class. The constituents of the index should be tradable that is, have a relatively liquid market with regular pricing. The constituents and characteristics of the index should be relatively stable over time. Ideally, indices should also be: Calculated regularly by independent providers Available historically to enable managers to understand the characteristics of the index. Figure 02. Does this performance tell us anything about skill? 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% -4.0% -5.0% Source: evestment, MSCI... even if a manager s benchmark was the most appropriate choice when the manager was appointed, manager benchmarks should be reviewed to make sure they are still the right fit several years on. Equity investing: Insights into a better portfolio 63

64 03 Manager monitoring Market-weighted benchmarks One example of how benchmarks are important for passively managed assets is the recent development of alternatives to the traditional market-weighted benchmarks. The majority of commonly-used benchmarks are weighted according to the market value of the securities that a company has in issuance. The benefit of this approach is that it gives exposure to the whole of the available universe at low cost. However, there are also several drawbacks with this approach: Market-weighted benchmarks hold more of a security as it increases in value. If a security becomes overpriced and then falls in value again, the benchmark holds the largest amount of that security right before the price begins falling. Similarly, a market-weighted benchmark holds less of a security as it falls in value, and its allocation to a security is at its lowest right before the price begins to increase in value again. This means that market-weighted benchmarks tend to have high allocations to over-priced assets and low allocations to under-priced assets. For bond markets, a market-weighted benchmark has the highest allocations to the most indebted borrowers (the companies or countries with the most bonds in issuance), which seems counterintuitive. In recent years, investors have become increasingly aware of these issues, and index providers have developed alternative ways to construct a passive benchmark. For equity benchmarks, these tend to involve gaining exposure to different factors or approaches, such as value-weighting or targeting a certain level of volatility. For bonds, the focus has been on improving diversification and considering metrics which measure a company s ability to repay its debt. The purpose of a review is to better understand what exposures you are trying to achieve, and to better equip yourself to identify and reward genuine manager skill. Is the combination of market exposures in your portfolio appropriate? At an individual manager level, benchmarks provide a means for monitoring performance and for identifying manager skill. However, benchmarks can also be used to help to define and monitor your long-term investment strategy. Because of this, benchmarks are as important for passive managers as for active managers. A review of manager benchmarks can also provide an opportunity for investors to consider whether the combination of their active and passive managers styles and opportunity sets is appropriate when viewed at a total portfolio level. What about alternative asset classes? There are a number of issues specific to individual asset classes that require consideration. Here we consider private markets and hedge funds as examples where choosing an appropriate benchmark is particularly challenging. There are the three main types of benchmarks that are used for these investments; we highlight some key advantages and drawbacks of each. 1 Public market indices: these are among the most common benchmarks used for private markets in particular. Market indices can be useful to investors as they provide a comparison of how a manager is performing versus a portfolio of similar securities that are listed on regularly traded markets. However, the drawbacks to using public indices include: Public market performance is not directly linked to the main drivers of return for private market and hedge fund investments. Public markets tend to exhibit higher volatility than private markets and hedge funds (or at least appear to do so). For private market investments, portfolio returns are typically measured using a different calculation method to the method used for calculating market returns (private market returns are measured on an internal rate of return basis whereas public market returns are calculated as time weighted rates of return ). 64 towerswatson.com

65 2 Peer group indices: these are compiled by aggregating the performance of a group of investment managers in the same industry. This type of index is particularly popular for measuring hedge fund performance. Measuring a manager against their peers provides an indication of how other investments of the same nature have performed and avoids many of the issues related to the use of public market indices. However, there are many weaknesses of peer group indices which include: Peer group indices are not investable, as investors do not have access to all of the managers that make up the index. The valuation and performance methodologies can vary between managers, and often the managers reported performance is not verified by the index provider. Peer group indices typically include only those managers who choose to report their performance. This results in two key problems. Firstly, only the strongest performing funds report their performance generally. Secondly, funds that cease to exist possibly following a period of poor performance are removed from the index, and those managers past performance may also be removed. Both of these problems tend to result in peer group index performance being artificially high. 3 Absolute return benchmarks: instead of comparing a manager to its market or peer group, some investors choose to measure manager performance against a long-term performance target, such as 5% per annum. Other return targets include a margin above cash returns or a margin above inflation. The drawbacks to this type of benchmark include: They are not investable. Absolute return indices do not allow for market returns. Given all manager performance is linked to some extent to what happens in markets, an absolute return benchmark is unlikely to give a good indication of how that manager has performed given market events. This is particularly true for short-term performance. Given the pros and cons of each benchmark type considered above, it is important for investors to review their manager benchmarks on a case-by-case basis, considering both the characteristics of the particular asset class being invested in, and each manager s investment style and time horizon. As no single metric can provide a complete analysis of a manager s competence, we also think it is useful for investors to take a balanced scorecard approach: this approach supplements a quantitative benchmark with a qualitative monitoring process including a number of short- and long-term factors such as the quality of a manager s investment processes and various risk measures. Using the right benchmarks is important Reviewing whether your managers are being measured against the right benchmarks isn t about penalising managers, or trying to create benchmarks that are more difficult to beat. The purpose of a review is to better understand what exposures you are trying to achieve, and to better equip yourself to identify and reward genuine manager skill. Put simply, better design means better outcomes. These benchmarks can be useful for assessing the long-term success of a manager or portfolio relative to broader goals. Equity investing: Insights into a better portfolio 65

66 03 Manager monitoring What results should dictate firing a manager? Since the financial crisis, we have seen a number of managers with strong long-term track records produce performance way off the scale in other words underperformance of more than two times the expected tracking error. The key question clients should be asking in extreme circumstances is at what point is the result so bad they just have to move on. Here, we offer a general framework for answering that question. 66 towerswatson.com

67 Some context This question has arisen in large part on account of the credit crunch. The much higher market volatility and the fact that markets have generally been driven by highly technical factors and sentiment have combined to produce a large number of extremes in manager performance when viewed against their benchmarks (both on the positive and negative side). Many clients understandably have been surprised and concerned by the combination of exceptionally poor market performance and relative poor manager performance in some cases. The question itself is representative of a perfectly understandable attitude that trustees and other fund owners should be naturally biased to action. The philosophy is that if someone in business produces a poor outcome, they are accountable, so we should terminate their appointment and move on. For pension fund trustees to be action-oriented on behalf of their beneficiaries is particularly compelling, as there is a legitimate fear that the beneficiaries would look at any inaction as inadequate. But, is a bias to action, the right response in this context? We think this question sits alongside some other questions to which we provide answers below: Is poor performance indicative of poor work and what investigation is needed to decide? To what extent is failure to meet targets an outcome that suggests the termination of a manager? What action does extremely bad performance suggest if it is not termination? What buy/sell discipline in changing managers produces the best financial outcomes in the long run? Some commentary The principle is widely accepted that interpretation of past performance is complex. It is essential that we do some analysis, and the first thing to do with any performance figure is try to understand the reasons behind it. Was it a case of very poor work by the manager? Let us make the assumption that you started the period thinking your manager was skilful. In this situation it could be argued that there are four possible explanations for the bad performance. 1 Poor skill. This manager has not been skilful, either because something has happened to affect his skill or the original assessment of that skill was incorrect. 2 Poor decisions. This manager has made some misjudgements. The manager remains skilful, but has simply made mistakes. A few bad judgements should be expected and do not make a manager bad overall. 3 Poor luck. This manager has made some sensible decisions which proved unsuccessful due to events that could not have been anticipated. 4 Timing. This manager has a number of positions that have so far been unsuccessful, but there are reasonable hopes that they will turn around (this is not possible in some situations, such as companies that have been nationalised). Looked at this way, the appropriate action falls naturally into place. If 1 applies, the manager should be fired. In the three other cases, the jury is still out and changes do not appear to make much sense unless there are reasons other than simply a view of the manager s skill (for example, their fit in the manager line-up). It clearly calls for keeping things under more significant review, however. In the case of 2, the manager is definitely under a cloud and needs to regain your confidence. There is a caveat. You never quite know if the cause was poor skill, poor decisions, poor luck or simply timing. The best you can do is perhaps to put these in order of their likelihood, or where you see a mixture of more than one factor at work, then decide on their respective weights. Given that typically only poor skill should lead to termination, the decision is still reasonably straightforward. Equity investing: Insights into a better portfolio 67

68 03 Manager monitoring Why have so many managers underperformed since the financial crisis? Manager performances in 2008 were poor relative to their benchmarks in many cases. Within bonds, an unusually high proportion of active managers underperformed (often through being overweight non-benchmark assets); within equities a number of fundamental managers suffered. The credit crunch has produced highly abnormal conditions for all managers. Most investment processes analyse securities through the lens of fundamental values. They assess future income. But since the credit crunch the valuations of securities have reflected a number of non-fundamental factors like: Lack of liquidity Securities caught up in forced deleveraging Securities affected by government interventions A flight to (perceived) quality Other aspects of sentiment, in which fear has played a big part Could managers have adjusted their preferences to these conditions? We do not think that this was ever a realistic or, possibly, even desirable change. Many of these special considerations have been impossible to anticipate, have not been part of the managers natural philosophy and have involved taking a dangerously short-term view. Furthermore, the poor liquidity and increased transaction costs have meant any change of stance would have been very expensive to implement, for some managers prohibitively so. This account above does not absolve all managers of responsibility for their poor performance far from it and it will be the managers whose underperformance is extreme that have most to account for. Indeed one of the key questions managers need to be able to answer is whether their philosophy and process have been designed simply to work in an environment like the one that has been in place over the last 20 years, or whether they believe the approach is sufficiently adaptable regardless of the long-term market environment. We should also be careful about exceptionally poor past performance triggering manager changes which are destabilising. 68 towerswatson.com

69 What about when the performance is off the scale? The right response is that you have to investigate more deeply. When we refer to off the scale, we have in investment the concept of tracking error to guide our thoughts. It leads to the common rule of thumb that underperformance worse than twice the tracking error is off the scale. However, that rule of thumb needs lots of qualifications. First, it is important to note that through chance alone one should expect underperformance worse than twice the tracking error around one year in 40. Second, statistics in investment are often badly behaved. Tracking error is a backward-looking measure, which will be ill-suited to unusual investment conditions. That does not lead us to discard the measure, as it does a rough and ready job in bringing some semblance of clarity to bear on a subject that would otherwise be unworkable. Nevertheless, if we have a twice tracking error result, there is work to be done to decide why it has occurred. Most likely it will be caused by one or more of the following: A Chance (although as mentioned above, the likelihood of this is relatively low). B A so-called fat tail result, where circumstances have made a number of managers look like this because of their style or convictions of the moment. C A result attributable to one or more significant positions going against the manager (which may suggest a failure of risk control). D A result from leverage in the individual strategy, or more likely, the unwinding of leverage in stressed conditions. We should also be careful about exceptionally poor past performance triggering manager changes which are destabilising. So the assessment of a manager s underperformance will need to cover those factors which could produce a down-rating of the view about skill: Client losses producing damaging business changes, reduced resources, inappropriate leadership changes. Style responses that compound the problems, losing nerve at a critical moment. That said, we would expect well-managed investment organisations on the whole not to react in the wrong sorts of ways. All managers should be conditioned by the idea that they will underperform at times. All managers have had some experience of this condition. No well-managed business makes itself too vulnerable to performance down turns. All of these factors should provide some sort of protection so that a skilful manager with poor performance can rebound. All this guides us to the rational view that performance should not be a firing issue on its own. But this thinking risks missing an important emotional aspect of this extreme situation. When past performance is extreme, a client s exasperation will be real and large given the large loss (noting that it may be permanent or temporary, but it is far from clear which). Our instinct is to have a bias to action. We are all pressured by the thought that if this does not turn around we will be in a worse place. Yet we should take care with this reaction as it turns out that a bias to action generally loses the fund more than it gains. Can these be sorted by our 1 to 4 division earlier? The interpretations of C and D might well suggest a failure of skill which should call for termination. The others appear more likely to fall in the jury s out response. Equity investing: Insights into a better portfolio 69

70 03 Manager monitoring Is there a period of underperformance that should always lead to termination? Most people would argue that it seems reasonable that managers should be judged over five-year periods. That is certainly a period in which skill should generally emerge, but there is no law that it will. Five years is arbitrary and if used too slavishly it will produce premature judgements with resulting penalties. Really there is no substitute for assessing managers on both shorter- and longer-term measures. What buy/sell discipline in changing managers produces the best financial outcomes in the long run? The Goyal and Wahal research study in covered a very large number of US pension plans and their hiring and firing decisions. It demonstrated quite clearly the difficulties of changing managers. This picked out very strong evidence that investment committees were on average firing underperforming managers who subsequently saw their performance rebound. The record of hirings on average added a little value, but not sufficient to overcome the conclusion that the funds would on average have done better to stay put. The research is suggestive of the best process we can use to hire and fire managers. It incorporates these rules: Hire in numbers to get diversification and limit the impact of any single manager s underperformance. Hire based on a prospective view of skill, track record comes well behind. Fire when the evidence mounts that the manager has lost his skill advantage, again track record comes well behind. What is past is past. The manager line-up should always be managed with respect to the future. What beliefs should trustees have? While there is a need for trustees to review a list of beliefs for themselves, we think this is a concise set to build upon: Past performance does not tell you much directly about skill, but it does help inform the debate about skill. Manager line-up decisions need to be based on a prospective assessment of future performance. The psychology displayed in investment committees is often too emotionally engaged, which suggests the need to diversify across a number of managers to reduce the distress from any single manager s results. For a more advanced set of beliefs that Towers Watson employs in extreme conditions, you might consider these too: Tracking error, while broadly indicative of return dispersion, is highly state dependent, and so will tend to understate the probability of extreme events. At times of change, alpha (manager outperformance) may be extremely difficult to anticipate. In stressed conditions (when asset prices are materially impacted by shorter-term credit and solvency perceptions rather than by longer-term fundamentals), manager alpha may suffer in the short term with pricing uncertainties, but alpha is likely in subsequent periods to undergo some catch-up if those concerns dissipate, as has often been the case in the past. In stressed conditions, there are likely to be short-term correlations between alpha and beta (market returns). And the answer to our question at what point is the result so bad we just have to move on? Performance is not a necessary or sufficient condition to fire a manager, however bad it is. Only when the past performance is clearly happening alongside a loss of skill or a failure of risk control do we reach a point of no return or when a manager s results produces negative changes to business or style. What is past is past. The manager line-up should always be managed with respect to the future. References 1 Goyal, A. and Wahal, S. The Selection and Termination of Investment Management Firms by Plan Sponsors, towerswatson.com

71 Further information For further information, please contact your usual Towers Watson consultant or: James MacLachlan Global Head of Equity Manager Research Ben Griffiths Senior Investment Consultant, Manager Research [email protected] Equity investing: Insights into a better portfolio 71

72 About Towers Watson Towers Watson is a leading global professional services company that helps organisations improve performance through effective people, risk and financial management. With more than 14,000 associates around the world, we offer consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. The information in this publication is general information only and does not take into account your particular objectives, financial circumstances or needs. It is not personal advice. You should consider obtaining professional advice about your particular circumstances before making any financial or investment decisions based on the information contained in this document. Towers Watson Australia Pty Ltd (ABN , AFSL ) Copyright 2014 Towers Watson. All rights reserved. TW-AP March towerswatson.com