The search for outperformance and the challenge of cyclical returns

21 Jul 2015

Grant Watson | Joint Boutique Head/Portfolio Manager
Warren McLEOD | Portfolio Manager

As part of the Customised Solutions boutique within Old Mutual Investment Group, this team is responsible for managing two investment strategies: the Managed Alpha and Managed Volatility strategies. These strategies provide investors with alternative sources of outperformance, with risk management being integral to the investment process. Their managed alpha unit trust, the Old Mutual Active Quant Equity Fund, is top quartile within the general equity category over one, three, five, seven and ten years to the end of March 2015.

Key takeouts:

  • Excess returns: diversification or stock-picking?
  • SA fund managers have value bias
  • Most investors can’t stomach buy-and-hold

Most investors seeking to outperform established equity market benchmarks invest with a number of active equity managers. The vast majority of these active managers profess to outperform through the application of fundamentally based stock selection. We believe, however, that the bulk of the relative performance of these managers actually comes from their exposure to various sources of excess return. These sources of excess return include, among others, the small cap premium, value premium and momentum premium. This is contrary to many investors’ perceptions that excess returns are derived purely from skilled stockpicking.

Research shows that by consistently biasing a portfolio to one or more of these premia, an investor should outperform over the long term.

Long-term performance of strategies exploiting sources of excess return

To identify the relative performance of value, momentum and small cap strategies, we graphed the MSCI SA Value Weighted Index and the MSCI SA Momentum Weighted Index against the MSCI SA Index from November 2001 to January 2015. In addition, we graphed the FTSE/JSE Small Cap Index against the FTSE/JSE Weighted All Share (SWIX) Index.

As these charts show, in South Africa the momentum and small cap strategies generated meaningful excess returns over the medium term. It is interesting to note that the value-based strategy has not outperformed the MSCI SA Index over the past 14 years. After initially outperforming, the value-based strategy has underperformed significantly over the past six years, a period characterised by strong equity returns on the back of loose monetary policy, and quantitative easing.



The challenge of harvesting sources of excess return – cyclical returns

The experience of value-based strategies in South Africa over the past six years gives an insight into one of the drawbacks associated with harvesting excess returns from a single risk premium, namely that returns can be cyclical. This is best illustrated by plotting the relative performance of these strategies:


Sources: MSCI, Old Mutual Investment Group

This cyclicality has two main implications:

  • Investors aiming to extract this outperformance need a long-term buy-and-hold investment approach, and the risk tolerance to endure significant short- to mediumterm underperformance.
  • The timing of an investment aimed at capturing one or more of these sources of excess return can have a material impact on an investor’s long-term performance. This is well illustrated in the relative performance of both value-based and momentum strategies during the financial crisis – over this period, the charts are almost mirror images of each other.


We analysed the performance of the general equity peer group average from December 2001 to February 2015. The reason for choosing this group of funds is that it provides a good indication of how the average portfolio manager in South Africa performs relative to the market.

As displayed in the table, the average returns generated by general equity unit trusts were better than those of the market 54% of the time. This indicates that unit trust portfolio managers do, on average, add value to investors. However, it is evident that the good performance was biased under certain market conditions: when the MSCI Value Index outperformed the MSCI Momentum Index, the average return was better than that of the market 63% of the time. As suggested by its name, the Value Index has a value style bias. This indicates that the average portfolio manager is overweight in high value shares.

As discussed earlier, the Value Index has been through long periods of underperformance. It suggests that if you wish to have a smoother return path, you need to diversify your portfolio in terms of style risk.

Why have value-based strategies underperformed?

A possible explanation for the underperformance of value-based strategies, as well as for the cyclicality of returns, can be found in the Adaptive Market Hypothesis, as posited by Andrew Lo in 2004. This hypothesis implies that the degree of market inefficiency (and hence opportunity to generate excess returns) is related to the number of competitors in the market and the adaptability of market participants. These factors materially impact the waxing and waning of various strategies and, in turn, have a direct impact on the cyclicality of returns.

Prior to 2000, there were a limited number of value managers in South Africa. By implication, the opportunities open to valuebased managers were large, given the small number of market participants exploiting this source of excess return. Post the TMT collapse in 2001, a number of investment houses reinvented themselves as value-based managers. “New era” funds were closed and investment houses that were historically momentum or growth managers restructured and became value managers. Given this shift, the number of investors seeking to exploit the value premium increased and, consequently, the opportunities to profitably exploit this value premium declined over time.

An alternative approach to harvesting sources of excess return

Conventional approaches to exploiting risk premia generally involve exploiting one source of excess return on a buy-and-hold basis. Although this approach should result in outperformance over the long term, short- and medium-term underperformance can be significant. Many investors simply cannot tolerate these periods of underperformance. The net result is that investors switch strategies at the wrong time, resulting in long-term underperformance. This was highlighted in Morningstar’s research that compared fund returns with what investors actually received. At the end of 2013, the 10-year gap between the return the average investor received and what the average fund delivered, was 2.49% a year. Compounded over the 10-year period, this has a significant negative impact on an investor’s portfolio.

Given investor behaviour as outlined, diversification across different sources of excess return becomes an attractive proposition. Not only should such an approach result in outperformance over time, but this outperformance should also be much more consistent, and the overall portfolio less prone to periods of cyclical underperformance. In addition, the riskreward relationships for risk premia are constantly changing as market conditions change. Diversification across a number of risk premia (value, momentum, size, risk etc.), combined with an allocation approach that successfully adapts to the changing market conditions, should give the best long-term return outcome.

  • Customised Solutions
  • Saliegh Salaam
  • Grant Watson
  • Fundamentals