(February 13, 2014) — Advancements in equity investing mean investors should regularly review and evaluate their equity portfolios, taking another look at risk premium drivers and any highly concentrated portfolios, consultants Towers Watson has warned.
Today’s asset owners are presented with myriad innovations and options as the industry bounces back from the financial crisis, and complexity has been added to the “essential building blocks of an equity portfolio,” a report from the consultants said. Equities have evolved beyond the simple dichotomy of beta and alpha.
“In a highly competitive world, we believe asset owners should simplify their strategy (for example, go passive), or raise their game in order to deal with this complexity and benefit from it,” said Jim MacLachlan, Towers Watson’s global head of equity manager research. “It is no longer sufficient to have an allocation to bulk beta and one or two active managers to construct an equity portfolio. The onus is now firmly on asset owners to develop their own portfolio construction skills or delegate this task to third parties.”
Smart beta is one strategy to capture a particular risk premium for a relatively low cost.
As investors are able to identify their funds’ goals, they can form systematic smart beta plans to “exploit recurring opportunities that are expected to persist over time,” according to Towers Watson.
The report also found that investors were more prone to hitting high levels of expected excess returns with “more concentrated portfolios with assets focused in the manager’s highest-conviction ideas.”
“Studies have shown that portfolio managers often add value in their high-conviction stock picks but destroy value with the unintended underweight positions in the portfolio,” the report said. But a concentrated portfolio—as opposed to a diversified portfolio—could offset these underweight positions.
However, index funds may better serve investors with less robust governance structures and streamlined investment processes, as they may be unable to endure periods of underperformance, the report said.
“While there are greater expected rewards from the [complex] approach, it requires more internal governance and portfolio construction skill from the asset owner, and therefore may not be suitable for everyone,” MacLachlan said. “Asset owners should determine what level of complexity is appropriate, given their requirements and their governance levels.”
Towers Watson also found low volatility equity strategies becoming more popular among investors who were attracted to high returns with lower risk.
Low volatility equity pursues to exploit “anomalies” such as high-beta stocks underperforming low-beta stocks. However, jury is still out on whether investors are able to overcome challenges that accompany these anomalies—some excess returns that occur from low volatility equities could make investors sell early before their return potential is realized, experts have warned.
Related Content: What It Takes to Go Smart Beta