Achieving Alpha Without High Fees: UK Equity Research as an Example

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With lower-cost alpha strategies becoming more readily available, fund managers are under more scrutiny for the value they can add relative to the fees they charge.

The trend towards low-fee strategies reflects a partial global shift from active investing towards passive alternatives, which carry lower fees and often perform well on a risk-adjusted basis. Both approaches aim to extract the risk premium associated with investments or their underlying factors.

One aspect of active fund management which has been in the spotlight recently is the fees charged by investment managers for equity research, which are often charged on a commission basis and attached to trades.

Hong Kong-based startup Seed Alpha made headlines when it launched in 2015 since it sought to change how investors paid for investment research. Seed Alpha lets clients hand-pick the equity research reports they want, rather than paying for a constant stream of reports from which only a few may be of value to clients. The company was called the “iTunes” of equity research by some media outlets since it mimicked the ability of users to find and pay for only the content they wanted.

The company is targeting the gap in the market for the pay-for-what-you-use approach, while also capitalising on new rules in places like the UK which mean research has to be priced and says audit trails have to be in place to improve accountability. Information disclosure also plays a key part of the rule changes, since transparency about the source and proceeds of fees has been lacking.

The aim of the legislation is to ensure fees are justified and not spent on things other than research, as has been the case for some time.

The UK’s Financial Conduct Authority (FCA), which was behind the changed rules, said in 2013 that a large portion of clients’ commission for equity research was going towards what the FCA called “corporate access” – or the ability to gain access to the management teams of companies the investment firms were eager to invest in. The FCA estimated that based on available information, £500m of dealing commission was spent on this alone in the UK in 2012.

Clients of investment managers were in many cases paying for a wide range of services which they were often not even making use of. As are its counterparts in other regions including Europe, the FCA is trying to make sure all fees paid to portfolio managers are justified.

But many investment managers, of course, do add significant value to portfolios while ensuring costs are vindicated. The heightened focus on fees and other factors has, however, raised the need to adequately assess a fund manager on the value they add relative to the fees they charge.

At a broad level, a fund management firm can be assessed on its ability to generate alpha (or returns which beat a benchmark index).

While alpha generation is one aspect of performance, managers should be evaluated against their specific mandates.

Some investors might hold their investment manager to account over their ability to mitigate risks in the markets in which they operate. This could include selecting the appropriate blend of alpha sources (particularly those which tend to be relatively uncorrelated and therefore help to smooth returns even through crises in equity markets).

Alternatively, clients with a different approach may evaluate their manager on the ability to simply track the relevant benchmark in a cost-effective manner. Others look at the manager’s ability to generate healthy absolute returns – which are not measured against a benchmark.

Investors can use a number of financial performance ratios to assess the long term performance of a fund manager, including the fund’s standard deviation score, which shows whether the manager’s strategy is volatile or stable and consistent.

Similarly, beta measures how volatile a portfolio or fund is relative to a benchmark. For US-focused funds, the usual equity benchmark is the S&P 500 Index, while a UK equity investment may be compared to a benchmark in the FTSE range of indices, among others. A beta of more than 1 indicates that a fund is more volatile than its benchmark, while a beta of less than 1 implies less volatility.

While some investors might be willing to accept high volatility (a high beta value on their investment) since this can imply higher returns during upside volatility, many prefer more stable funds over the long term.

Investors prepared to take on additional volatility would want to be compensated with a greater risk premium, and would assess their fund manager against this metric.

These financial risk ratios (alpha and beta) help in the overall analysis of an investment manager, and indicate whether or not the manager is delivering on the given mandate relative to portfolio specifications. This could include appropriate blending of alpha sources – or combining those which are uncorrelated in order to manage risk.