Unconstrained investing: is freedom from indices the future?

The traditional market cap weighted benchmark may continue to rule the day, but institutions are increasingly looking to plough other investment fields. Alternative indices have gained traction but attention is also being focused on unconstrained investing which offers greater freedom in portfolio construction.

Whether it is equities or fixed income, unconstrained investing is not easy. The strategy is only as effective as the manager’s ability to identify and implement the right ideas.

Daniel Phillipson

The trick, of course is finding the right fund manager who can adroitly navigate the markets. This is not such a simple task. Active management in general has been a hard sell due to weak performances and high fees over the past decade.

Although returns can vary on an annual basis, the figures from the Mid- Year 2012 S&P Indices versus Active Funds Scorecard (SPIVA) which looks at one, three and five year periods, shows a consistent pattern. Over the last five years, for example, US active equity managers in all asset categories failed to outperform the corresponding benchmarks with the exception of large-cap value. More than 65% of the large-cap active managers lagged behind the S&P 500, over 81% were outperformed by the S&P MidCap 400 while around 77% of the small-cap funds undershot the S&P SmallCap 600.

Fixed income managers did not fare any better during the same time frame. More than 83% of general municipal funds underperformed the S&P National AMT-Free Municipal Bond index, 93% of government longterm funds trailed behind the Barclays Long Government index while nearly 95% of high yield corporate bond funds failed to outshine the Barclays High Yield index.

It is not surprising then that investors looking to go down the unconstrained route are advised to conduct rigorous due diligence on prospective candidates. The checklist should not only include the fund managers’ track record but also methodology – whether it is fundamental or quantitative – and their ability to chose the right stocks, including new growth companies before they become part of the index. The same disciplined criterion should be applied when assessing an untethered fixed income portfolio.

“Simply put, whether it is equities or fixed income, unconstrained investing is not easy to do”, says Daniel Phillipson, product manager for Pimco’s unconstrained investment strategy. “The strategy is only as effective as the manager’s ability to identify and implement the right ideas. It is difficult to replace beta with alpha and it requires a robust process and resources.”

One of the problems, according to Richard Skelt, head of investments in Fidelity’s Investment Solutions Group is that there can be periods of underperformance and managers need to have the courage of their convictions when pursuing an unconstrained approach. The issue is short-termism. “If you get judged and incentivised on a quarterly basis then you are more likely to manage your fund closer to the benchmark. If it takes longer than a year to generate out performance then that makes many trustees uncomfortable.”

A matter of skill

Nick Sykes, European director of consulting at Mercer Investment Consulting echoes these sentiments. “If you have a genuinely skilled equity manager, then give him as much rope as possible, but I think this skill is scarce in the long only world. It is much more evident with hedge funds but you will have to pay a high price. It is difficult though to add value because even if the manager has a consistent philosophy there will be periods of underperformance and most people do not have the tolerance for it.”

The problem, according to Jeffrey Molitor, chief investment officer Europe at Vanguard Asset Management, “is that there are very few managers who have the insight along with the conviction and the ability to keep an eye on what needs to be accomplished to do unconstrained investing. The big question is what are they trying to beat?” If they are a long only manager, then the answer is typically a market cap weighted benchmark.

As Carl Beckley, managing director, relationship management, EMEA at FTSE puts it: “Unconstrained investing is another way of investing to produce better results with the right manager, but investors and investment consultants still see traditional market cap weighted indices as the definition of the opportunity set of a given market or markets, which is strongly embedded in the markets’ psyche. Market cap weighted indices are still broadly used as benchmarks and they also have billions of dollars passively managed against them. However, that doesn’t mean this is the only way to invest using indices.”