At a time when mutual funds and professional money managers are struggling to produce acceptable performance, many are throwing away hundreds of basis points each year via high expenses and transaction costs. But many equity fund managers and their bosses don't seem to care.
That's because the concept of embedded alpha works like strong sleeping pills for many investment-company executives. It is not a subject that excites them, nor is it likely to be discussed at cocktail parties. Officials at many of the biggest companies candidly say that they don't pay attention to it. Some aren't even sure what it is.
Embedded alpha is the daily expense of running an actively managed portfolio. Each basis point of embedded alpha can result in the reduction of a fund's performance. Because a fund's total embedded alpha can run into the hundreds of basis points, the effect on performance can be dramatic if the market turns flat or heads south.
"At a 20% rate of return, a 2% to 3% fee didn't matter much. It may have hurt relative performance, but it wasn't noticeable," says John Casey, chairman and co-founder of Barra Strategic Consulting Group in Darien, Conn. "As these returns change and decline and as costs become 20% to 30% of the return off the top, then things could change."
There is more to the concept of embedded alpha than a simple management fee. "These costs include brokerage commissions, the opportunity cost of not equitizing cash tax liabilities, and the negative market impact of trading," says a Barra/Merrill Lynch report entitled "Success in Investment Management."
When all expenses are added up the costs are "astonishing," says John Bogle, a founder of the Vanguard Group of Funds. At a recent conference, Bogle said that a typical managed institutional fund has a total annual expense ratio of 90 basis points. But, when transaction costs are added, the ratio rises to 160 basis points.
"One hundred sixty basis points is a lot of embedded alpha. For example, in a market returning 10%, costs are taking 16% of annual returns," Bogle said. But the idea of embedded alpha apparently is not considered an important issue among some investment companies. Barra researchers say it is a concept that the fund industry, amid a period of poor performance, will ignore at its own risk in the future. Embedded alpha might be a critical factor for some struggling funds and investment companies.
Conversely, controlling expenses could be a key component of good fund performance over the next few years, provided a fund company has a comprehensive plan for claiming this alpha, according to a group of researchers. Exploiting embedded alpha could push a fund into a higher decile. For example, according to the Barra study, the difference between finishing in the second and third decile in large-cap growth funds is 1.4%. The difference between the second and third decile in small-cap growth funds is 1.7%, and in international equity, the difference is 1.5%. The difference between the first and second decile is larger, generally somewhere between 3% and 4%. However, the differences in each level between deciles two and nine in these three categories is generally about 1% at each interval, according to Barra.
Finishing in a higher decile might be the difference between a fund surviving or being merged into another in bad times. It could be a reason for a fund company continuing to justify a management fee, according to several studies. That's because embedded alpha costs can run into the hundreds of basis points. They can be broken down into three types of costs: tangible, which are management fees and commissions, invisible, which is the market cost of trading a security, and managed, which are the expenses of building a portfolio.
Still, the concept is apparently boring enough to escape the attention of senior management at many fund complexes. It is something that many people in the investment-management business find underwhelming.
Embedded alpha covers a number of factors including transaction, tax and market-effect costs. But the concept was a nonfactor in a period when funds routinely were returning 20% a year-as the markets did for five consecutive years in the late 1990s. One downside of these fat returns is many active equity managers became sloppy, ignoring costs as long as markets were good. However, in more normal markets, says one fund researcher, these costs can be critical.
Some fund officials don't understand the concept of embedded alpha. Others don't think it is important. An industry observer says embedded alpha is hardly a factor these days. "I really don't know anyone who is looking at this. It doesn't seem to be too important," adds Russel Kinnel, an editor at Morningstar, the Chicago-based fund-rating service.
Don Peters, a fund-performance expert and manager of the tax-efficient funds with T. Rowe Price, explains: "We have a variety of analytical tools at (Price) that allow us to review any portfolio and its risk structure, based on some of these theories. However, it would not be accurate to say that these tools contribute significantly to the portfolio-management process."
Barra has written several reports examining the concept, urging the investment-management industry to take advantage of the opportunity for superior returns. "Embedded within these frictional costs is the opportunity for managers to systematically improve their performance," Barra argues.
Some industry observers and critics say that fund companies with no strategy for unlocking embedded alpha are running the risk of delivering lackluster returns. In the case of marginal fund companies, this could threaten their long-term independence or survival. They say that embedded alpha will be a priority of the best fund companies if, as it appears to be, stocks are in a bear market or performance is returning to single digits.
"We believe this is an opportunity to systematically improve performance," says Christoper Acito, managing director of Barra and the author of a report on the subject.
Acito, however, says it is no surprise that most equity managers and investment companies are uninterested in the idea. "Who cares about a few hundred basis points when markets have been good? Nevertheless, for those who are used to working with smaller margins-like fixed-income margins-this is something they have been paying attention to for years," Acito says. And, for equity managers, it should have a higher priority if returns are reverting to the mean.
This opportunity obviously is greater at the lower end of the performance scale than at the higher end. For example, Acito, in a chart he prepared for a paper on embedded alpha, notes that with an annual rate of return of 20%, a 1% fee only represents 5% of the fund's performance. But at a 10% return, a 1% fee represents 10% of performance, which is twice as much. With an annual 6% return, the 1% fee becomes 16.7% of performance.
The individual opportunity for a fund to use an embedded-alpha strategy depends on the kind of fund, an investor's tax situation and the trading practices of the investment company, as well as other factors. However, Acito estimates that-for the active equity manager-the opportunity would range from "several hundred basis points" to up to "700 or 800 basis points."
Acito's paper warns that, if managers and companies don't take steps to rein in these costs, management fees could be the first target of unhappy clients with unsatisfactory returns. "In order for active managers to protect premium management fees, management of the various aspects of embedded alpha must become a business imperative," Acito argues.
Another element of embedded alpha is the cost of keeping too much of the portfolio in cash. Say the equity part of a portfolio earns 10% more than cash in a given year, Acito says, and 5% of the portfolio was in cash. What impact, Acito asks, does it have on the fund's performance? "You've just lost 50 basis points over the course of a year, just for one element of embedded alpha," Acito says.
Without a formal embedded alpha policy that is championed by a high-ranking official of a firm, investment companies risk seeing their best funds transformed into laggards, fund industry observers warn. They add that fund companies, many of which have prospered in a era of consistently strong returns, are today burning up returns by ignoring these costs, which can be hundreds of basis points a year.
Fund companies must pay more attention to the concept of embedded alpha, Barra officials warn. Those that take advantage of it, they add, will be able to use the concept as a way of claiming superior performance. "A credible approach for managing embedded alpha will differentiate a manager in the marketplace and should be aggressively promoted," says Gregory Rogers, a former managing director for Barra and author of several papers on embedded alpha.
Although embedded alpha appears to be a method by which every active manager can improve performance, there is skepticism about whether it is going to have much of an effect on the industry. "Embedded alpha has been talked about for many years informally, but things will have to change before it's actually going to change things," says Don Cassidy, a fund-industry analyst with Lipper.
Cassidy thinks Barra's estimates that some funds are throwing away several hundred basis points in embedded alpha are exaggerated, but he believes 100 or 200 basis points a year is realistic. Nevertheless, the fund industry, he adds, is not going to incorporate these ideas in the short term. "It's tough to change a culture. It's tough to change a business in which the portfolio manager has been a king or a queen for so long," Cassidy says.
Barra consultants agree. They are not optimistic that the fund industry is going to start imposing these cost-saving techniques on their companies. Casey says that "few companies are doing this and a few will take advantage of this in the short term."
It may be that the industry has enjoyed such healthy margins and favorable markets for so long that its executives see little incentive to insist on changes that might upset fund managers. It may be that embedded alpha is too simple a concept for the fund industry. It may be the idea that the concept-a relatively easy way of improving performance merely by more closely watching costs and changing some business practices-is too boring for many fund executives. It may be that many officials in the industry think that a few hundred basis points doesn't matter to most shareholders. But at a time when mutual funds are being challenged by separate accounts, exchange-traded funds and customized portfolios, smart fund-company executives are likely to examine this issue more closely.