Asset managers like to say that skill is rewarded. Skill is believed to lead to the excess returns our clients want us to achieve. But what is the basis of that skill? Is it the gray hair that comes with experience? More than 10,000 hours of practicing clearly helps, but it is no clear recipe for success. Does superior brain power play a role? One can doubt that because remuneration policies in our industry make it possible to hire competitive teams for shops across the board. That structural factor practically assures that the same team will not become world champion year after year.
Decades ago, a lot of “skill” had to do with better or faster access to information. Then, with the entry of scientists into finance, superiority in analytic tools became the game in town. But both of these foundations of assumed skill are worth less (but not worthless) these days. Information gets quickly disseminated over the Internet and via social media, and it seems that only the lightning-fast reactions realized through high-frequency trading can still be beneficial. Meanwhile, quantitative models have become so widely spread that these can hardly make the difference. The limitations of analytic tools became apparent during the credit crisis of 2008, when it turned out that, for too many managers, “skill” was simply running a higher risk profile than benchmarks.
If skill is hard to identify, should investors turn to passive investing or enhanced indexing? We seriously doubt that. Although it makes sense to consider passive alternatives while building asset portfolios, in the end, the passive-investing industry doesn’t question the validity of the chosen benchmarks well enough and often shows surprisingly high total expense ratios, particularly outside of the U.S.
We may be lucky, but in all likelihood, over the next ten years, financial markets will offer relatively low absolute returns — let’s say 5 percent annualized for a 60-40 portfolio. This means that the urge to add additional returns through active management will increase. So what can we do?
We believe the factors that will make the difference are actually rather basic: labor, creativity, entrepreneurship and timing. Moreover, we believe that the scope of the traditional system of pay for performance should be expanded to include not only efforts to achieve idiosyncratic returns but also the well-organized harvesting of systematic market returns. On the other hand, those rewards should be moderated a lot to reflect the fact that the investment industry may be full of prima donnas but few have the skill of a Lionel Messi. That is to say, we are not talking about unique talents that all of us investment professionals possess.
At APG the strategy to address these issues consists of three approaches. First, our asset class teams have put a lot of work into developing smart beta strategies that benefit from fallacies and biases in market benchmarks. Our teams try to harvest premiums from systematic risk factors that they can identify and isolate. At the same time, we have deemphasized, but not abandoned, our long-only alpha approach to make sure that we continue only those idiosyncratic strategies in which we have a proven edge — and are able to explain the source of that edge. In the evaluation of those focused alpha strategies, it is also important how well those strategies offer diversification versus our clients’ pension liabilities.
Second, we have put more emphasis on labor as opposed to skill in our alternative asset–class approaches. With hedge funds a skill-based approach assumes that all managers are engaged in a zero-sum game, in which one player’s gain is another’s loss and the best managers are the ones who succeed in winning more than they lose. Some hedge fund managers, however, are engaged in win-win games. They pursue strategies that are mutually beneficial to them and the sellers of securities. These strategies are really about providing a financial service for a profit. A few examples include providing insurance and liquidity and facilitating compliance. APG invests primarily in hedge funds that earn a “service premium” for embracing complexity and bearing illiquidity, by focusing on areas such as intellectual property, distressed debt and catastrophe bonds. The demand for those services is likely to increase in the next few years as regulated financial entities face more stringent rules for leverage and risk-based capital and look to divest noncore activities.
Finally, there is timing. We realize that risk premiums may disappear over time and that service trades can be arbitraged away. Insights derived from our tactical asset allocation techniques enable us to make our style dynamic. Through this approach we hope to bear out the adage that it is not the strongest nor the most intelligent of species that survives, but the one that is most adaptable to change. • •
Ronald Wuijster is chief client officer of APG Asset Management, which is the Netherlands’ largest pension manager with €337 billion ($452 billion) in assets.
