Last week the LA Rams won the super bowl. Coach Sean McVeigh built a team with a deep bench of superstars. Wide receiver Odell Beckham Jr went down with an injury in the second quarter, but he was one of many skilful catchers in the Rams line-up. Any one of a dozen players could have been MVP in the big game. By building a team with a deep bench, McVeigh reduced his key person risk.
Other teams in the NFL rely on a franchise player, usually the quarterback. This person becomes the face of the franchise. The risk, of course, is if that one player is injured or has a run of bad form the team suffers more.
There is no doubt, in sports, talent costs money. The same is true in funds management, hence the willingness of investors to pay the premiums of active management. With active management, investors pay for the expertise of the star fund manager and/or the deep bench of analysts. The industry is rife with fund managers and investment gurus that live and breathe markets. Some genuinely have talent identifying opportunities while for others the self-belief is misplaced and they were just lucky, in the right place at the right time.
The difficulty for investors is determining if their active fund is managed by a deep bench of stars that are skilful, not lucky. This is easier said than done, as many fund managers are not transparent. It is difficult to get a complete list of holdings to determine how they are outperforming. Global research house Morningstar repeatedly ranks Australia last out of 26 global markets in terms of investment disclosure.
Ideally, investors should be able to assess performance, over a long period. They should be able to look at the holdings and determine, did a fund outperform because they are skilled at choosing the best securities, or were they just more heavily weighted into growth assets and/or those asset classes that have done best over recent periods? Performance should come from multiple sources, across sectors, not just a single idea. In addition, outcomes should be persistent and consistent with your expectations and their marketing.
If a fund manager says their skill is identifying ‘value’, you would expect when value shines, as it is now, so should they. Likewise, when a manager says they specialise in identifying ‘quality’ companies, you would expect they would fall less and recover faster during a downturn, as that is a key characteristic of quality.
It would be naïve to think your manager can outperform every month. Fund managers are human after all, so that means they will make mistakes. In investing, mistakes include selling too soon, holding a stock for too long and overlooking opportunities. Making mistakes can make some fund managers better investors but mistakes can lead to underperformance and as humans, they may get impatient and try to chase returns, or hold that stock they’ve fallen in love with, a stock which is cheap for a reason. As investors, we are human too, so persistent underperformance may lead us to run for the exit too.
So what is an investor to do? There is of course a way to eliminate key person risk. It is called passive management. Passive management, which aims to replicate the returns of an index as opposed to active management that aims to outperform an index.
That is not to say the days of outperforming the market are gone. Investors that still want to achieve an outcome different from the market benchmark index and to take the ‘human element’ out of their portfolios could turn to smart beta ETFs.
Smart beta, being the intersection of active and passive management, can explain a considerable portion of an active manager’s risk and return characteristics. However, it is not subservient to the human condition and our vulnerabilities. It does not ‘fall-in-love’ with stocks, is not impacted by what else is going on in its life and it does not retire or resign to work for a competitor. Importantly, there is a human behind the research and design of smart beta indices, and over the last 50 years, it has become more sophisticated.
Smart Beta ETF strategies are fully transparent so investors can see the holdings on a daily basis.
No fund manager, and for that matter, no index strategy will offer absolute returns all of the time – that is alchemy. Investing involves risks. Key person risk is one such risk. Prudent investing means not just diversifying your bench across asset classes but also across investment styles.
The key for investors, we think, is to diversify and seek those strategies that endure through the cycle and complex gauntlet that capital markets exhibit time and time again. It is common now to see smart beta as the core of a portfolio supported by high conviction active funds, or to see a core active manager blended with a complimentary smart beta strategy.
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