The Unbundling of Investment Returns

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  • 05 mins 10 secs
Investor preference is trending toward “unbundled” products, where investors can select and pay for a specific component of return, says Colin Moore, Global CIO for Columbia Threadneedle.


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The unbundling of investment returns
Colin Moore, Global Chief Investment Officer

If you're being asked to pay a premium fee for an active product that really hasn't delivered over time for you, then I think it's a fairly natural question to say, "Should I unbundle this and buy the elements which have been delivering?

We've been discussing this concept of unbundling for some time. The easiest product to think about in that is a straightforward equity product. There are really three things that make up the return that you get from an equity product. There is nothing new in this. Perhaps our ability to analyze and identify them is better, but these conditions have existed for all the decades that I've been in this industry.

So the first one is known as beta. And all that is is really the sensitivity to any equity product, to what's going on in the broad marketplace. The easiest one to think about is the S&P 500. If the S&P 500 rises by 10%, and your product generally rises by 110% of that, i.e. 11%, then you've got a beta of 1.1.

There's another element which is today known as smart beta, but for many decades was simply known as factor investing. That is less common. It is less prevalent in the return. But it is there and it's fairly persistent. Easiest way to think about that is a lot of funds have bias towards value versus growth or size. A small cap fund versus a large cap fund. But there are other factors such as momentum or quality that are all there. Less visible to many investors, but they've been there for many years and certainly they are things that we exploit in our day-to-day business in trying to help our clients.

Then there's this other element to it which is much more rare, but also much more valuable, called alpha. And that is where you create part of the return that's not based on these market sensitivities or factor sensitivities that I mentioned earlier, like value or growth. There is something unique about the investment you make that creates this what's known as idiosyncratic return. It's not explained by anything else, and also it tends not to be correlated to other things that are going on.

And when we think about diversification, people often make the mistake of buying lots of things. That will not help you in diversification. It's a very, very bad misunderstanding. If those things are highly correlated, i.e. they work in tandem with each other, you're really not getting any benefit from owning them. But where you can find things that have these alpha factors in them, where they have this idiosyncratic risk, it's something that's unique to the investment, then that is very valuable because it tends to be both good return and good diversification.

So what we're realizing now is that we need to be able to offer those services to people in the same way that other industries are beginning to break apart their packaged offerings. The analogy we've used is the cable TV industry, that people don't necessarily just buy the full package any more. People now buy the internet service and add what other elements they want for their entertainment. We will increasingly see investment products in the market place that are unbundled. You may want to buy the beta on its own and that's already a fast growing area in the marketplace. Clients may generally know that as passive investing, where you're buying this straight forward beta exposure, and we believe that's so common and so easy to replicate that clients should be able to buy that at very, very low cost.

The smart beta factors are harder to work with, particularly if you combine them together, and require more experience and more knowledge, and they're also slightly less common. Hence, they will be priced higher as an individual source of return. And then alpha I think will continue to be priced at a very high level.

The first reason why we're seeing this unbundling is that it's technically more possible. But I think it's really being driven by client demand and some of that is generational. We've also seen a lot of pressure over the last 20 years or so in the growth of indexing or beta investing. That's because many active managers, we just have to face up to it, have not done a good job in outperforming the benchmarks that they've been set.

Now some of that has been caused by this extraordinary monetary policy. When central banks are cutting rates dramatically, that's akin to the rising tide lifting all the boats. If you believe that is going to come to an end, then I think you're going to need to differentiate within your investments more and I think we'll move more to this multifactor investing, value versus growth, small cap versus large cap, high quality versus low quality. All of that is going to become important because who will benefit most from these difficult economic conditions is going to become a bigger issue. And, of course, then the premium on alpha is going to be restored. Those that can do it will I think command quite a premium in the marketplace.

The views expressed are as of July 2016, may change as market or other conditions change and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate.

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