This suggests that investors would have achieved better returns than eight out of ten managers by simply investing passively in broad market indices. Unsurprisingly, this is one of the key selling points put forward by passive investment investors and advocates.

Another argument regularly put forward is that passive products, such as market Exchange Traded Funds (ETFs), are generally offered at substantially lower fees than the typical actively managed funds. It can be a convincing argument because, after all, why would an investor willingly pay generous active fees when a relatively cheaper market ETF would have outperformed most managers?

The short answer is that these passively managed products structurally offer no means of generating outperformance. Most investors want to beat the market, and by design, the best return passive products can offer is the less than ideal market return. In fact, completely passive products are most likely to also underperform the market indices when all investment costs are taken into account. Running an investment portfolio attracts all sorts of costs that, in the absence of any hope for positive outperformance, will undoubtedly compromise the portfolio’s performance over time.

Does this leave active management as a logical choice in the pursuit of positive alpha? Active equity managers have traditionally relied on their superior investment expertise in identifying and picking shares that they hope will outperform the broader market and, in so doing, generate positive alpha. While this approach can certainly generate positive alpha when successfully executed, historical performance data shows that this alpha is often not consistently positive. Even if you choose a manager that has outperformed the market, they do not do so all the time. Moreover, the data also reveals that there has been no significant autocorrelation in their alpha. Simply put, a manager’s current or past outperformance has had little influence on their future outperformance. Finally, the historical performance also shows that the magnitude of this outperformance is significantly skewed to the left. Stated differently, outperforming managers have barely outperformed, while underperforming managers have significantly underperformed.

Given that only a minority of managers generate positive alpha, those few managers that do outperform tend to do so inconsistently and are therefore difficult to identify, and the magnitude of the outperformance is narrow relative to the underperformance, it is no surprise that investors are increasingly seeking alternative methods of adding consistent alpha away from the traditional stock-picking approach.

One such method is through portable alpha, also sometimes called alpha transport. This approach, which we extensively employ in our Prescient Core Equity strategy, allows us to import alpha that has been generated elsewhere into an equity product. Doing so takes advantage of the best of passive and active management to deliver consistent outperformance.

To illustrate the concept, let us for a moment consider a hypothetical investor that has made the decision to invest in property and is therefore in the market to purchase a house. Suppose this investor has been diligently saving up for this and is fortunate enough to have the full purchase price available in a money market savings account that is earning interest at 5% a year. While working through this transaction and considering the various ways to structure the investment, the investor comes across a financing offer for the property at an annual interest cost of 4.5%.

The investor does not need financing because they could simply use their savings to make the purchase without incurring any interest costs at all. While this might initially seem like the obvious route to take, it would regrettably also mean that they forego the 5% a year interest that the cash is currently earning in the savings account. The investor has another choice. They can alternatively opt to go with the financing offer and still get the desired exposure to the property without necessarily relinquishing their interest income. Critically, with the cost of funding at 4.5% a year, 0.5% lower than the 5% interest income currently earned, the investor stands to earn what is referred to as a positive carry on the transaction. Simply put, this investor will have the full exposure to their property investment and its potential capital gains, while also generating a return of 0.5% a year above the return on the property investment.

This is a real-world example of a portable alpha strategy, where the additional performance is generated from the positive carry, in addition to the return on the property investment. The investor has in effect created a structure where, without taking any additional risk, exploited the mispricing in the money market and mortgage lending market to generate systematic outperformance.

The same strategy can be employed within the equity market where investors finance their exposure to market indices at less than the money market rate. The major benefit of this strategy is that they get full exposure to the market indices (which incidentally places them ahead of 80% of the managers) while simultaneously importing systematic alpha from the money market assets into the equity component of the portfolio, which provides the additional performance over the market return. This retains the alpha-generative capability that pure passive managers lack, while providing consistent equity market returns.

Prescient has been employing the portable alpha concept within its investment strategy for over 15 years. It has contributed positively to the performance of our Core Equity Funds which continue to generate modest but consistent outperformance. DM/BM

This article was written by Seeiso Matlanyane, Portfolio Manager, Prescient Investment Management

Prescient Investment Management (Pty) Ltd is an authorised financial services provider (FSP 612).

The value of investments may go up as well as down and past performance is not necessarily a guide to future performance.