Stock markets have been on quite a run over the past nine years. The long, beta-driven rally put many active managers’ performance under pressure and led many investors to move some or all their equity allocations out of active strategies in favor of cheaper beta and factor exposure.

Today, there are signs that the beta wave may have crested, so investors are taking a closer look at ways to squeeze more return from their equities. Active management offers that potential, and the environment ahead seems to be more favorable for active. But which active managers simply rode the beta and style wave, and which ones possess true skill that’s worth paying for? How should investors think about paying for returns going forward?

We’ve been having a number of conversations with institutional investors about how to answer these questions, and we’re exploring ways to bring more transparency and clarity to the issues of manager performance and fees. There are various excellent tools already in use that are helping advance this dialogue. Over the past year or so, we have been talking to institutions about the idea of prime alpha.

About Prime Alpha

We designed prime alpha to identify manager skill by removing the cyclical impact of factor exposures and isolate the idiosyncratic components of return. Based on our research, prime alpha tends to be persistent over time: managers who deliver high levels of prime alpha do it more consistently than do managers who deliver simple excess returns versus a broad benchmark.

In developing prime alpha, we evaluated the returns of top-quartile active US large-cap equity managers from 1990 through 2014. When we ranked these top-quartile managers by traditional excess-return measures, just 24% of these top-quartile managers were still in the top quartile three years later, with less than half of the top-quartile managers (43%) staying above median. Using prime alpha as a lens, 32% of these managers remained in the top quartile three years later and more than half (52%) beat the median manager. We saw this persistence in prime alpha in other investment categories.

Prime alpha can help sharpen the focus on identifying skill when evaluating active equity managers who are part of—or could be part of—an institutional investor’s equity allocation.

Using Prime Alpha to “Look Under the Hood”

It’s easy to imagine a scenario in which an institution is considering a global value manager who’s faring very well versus their competition. But that performance might be driven by naive value-factor exposures rather than skill. Factor exposures can be highly cyclical, so their contribution to basic alpha measures shifts dramatically over time. We think prime alpha can help isolate managers’ true skill and help tilt the odds for investment success in investors’ favor.

Prime alpha can also help “look under the hood” of an existing equity allocation to better understand different managers’ performance drivers and help ensure that institutions have the right “mix.”

Emerging-market managers, for example, could be relying on very different mixes of beta, factor exposures and prime alpha to generate returns. One manager might be influenced strongly by strategic exposure to the small-cap factor, and another by skillfully timed mid-cap factor exposure.

A manager might also exhibit negative excess returns under the traditional framework, but positive prime alpha after adjusting for factor contributions. So, this manager may well be sticking to its investment philosophy in the face of cyclical headwinds, and can be expected to generate excess return over a longer horizon.

Similarly, prime alpha can help bring aggregate factor exposures to the surface. A small-cap equity allocation, for example, might have more exposure to the low-volatility factor than a plan sponsor is comfortable with. In this case, it might make sense to consider replacing one or more managers to reduce this exposure. Prime alpha can also help assess potential replacement managers to avoid reintroducing the same low-volatility overexposure.

Bringing More Clarity to the Fee Question

On the other side of the pressure to add return potential is institutions’ desire to take a fresh look at the fees they’re paying—and what exactly they’re paying for. According to a recent survey of institutional investors by a leading investment consultant, their top two concerns were whether active managers were providing the value add to justify their fees (49%) and whether managers’ fees were competitive (36%).

In order to make these assessments, it’s necessary to draw clear distinctions among the return drivers of each active manager. How much of the return is from beta, how much is from strategic factor exposure, and how much is from manager skill, or prime alpha? Of course, skill can take many forms: there’s skill in effectively designing and managing beta and factors—and there’s skill in idiosyncratic stock selection. But it’s helpful to understand the mix of return drivers to assess the value of each component and the implications for how much should be paid for it.

Separating returns into these ingredients can help institutions ensure that fees among their managers are appropriate and reasonable based on the mix. When making these evaluations, institutions also need to consider the other characteristics they value from certain managers in their lineup—for example, the value of a manager with the demonstrated ability to protect on the downside.

Of course, investors also want to avoid paying active fees for benchmark-like returns. We have seen this play out most acutely in mutual fund flows, where passive strategies have taken in most of the net new money over the past few years. We’ve observed some of this same dynamic among institutions, but we’ve also seen more consideration than ever being given to performance-based fees for active investment services. This includes more innovative pricing structures with passive-like base fees and a higher participation rate for excess returns versus the benchmark—a development for which we’ve been strong advocates.

A key consideration in these discussions is investors’ comfort level with the variability of performance-based fees, something that has slowed performance fee discussions in the past. We view performance fees as a great alignment of interest between asset managers and institutional investors—at the very least, it can make for a healthy discussion and establish a strong partnership.

More broadly though, we feel that prime alpha can put a fresh lens on the aggregate exposures of an overall equity portfolio and the roles individual managers play in that portfolio, and whether managers are delivering the value an investor expects.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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