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Decomposition of investment returns

Anthony Chouinard, CFA

Vice President, ETF Strategist (GTA & Ontario)

One of our biggest questions as advisors and investors is, What am I getting for what I am paying? Because of this, we wanted to review the drivers of performance when evaluating investment strategies.

When analyzing the drivers of returns for an investment mandate, one must consider two main attributers to performance: beta and alpha.

The first is cap-weighted index benchmark returns, or beta. No matter the investment style, beta always attributes a significant component of a long-only investment strategy. Even some of the most active managers attribute some of their performance to their asset class. If one's asset class has very poor relative performance, it would be very difficult for any strategy in that asset class to outperform other asset classes. An example of that would be looking at any Canadian equity strategy, active or index, and comparing it to US large cap equity over the past 10 years. Very few, if any, Canadian equity mandates have outperformed US equities. Beta is the equivalent of having the wind in your sails, in a positive or negative way.

The second component of an investment return would be the alpha (or active) return, which could also be split into two main drivers. The first would be the return from a static exposure to smart beta, also known as factor or style attribution. This is easily understood by looking at value managers over the last several years. Even if they were in a performing asset class such as US equities, the value style has significantly underperformed. Therefore, one's exposure or style, such as value, growth, dividend or low volatility, is one major driver of investment returns.

Finally, it's about generating pure alpha. Supposing that you are in the right asset class benefiting from beta and have exposure to the right investment factor or style, such as growth, it then comes down to the security selection process. Whether that be bottom up security selection, top down industry selection or factor selection, this is the final component of investment returns.

The crucial take-away from this discussion is that an investor needs to evaluate whether a mandate’s performance is driven by its asset class, its style or the management team, where one should allocate to tracking risk or possibility of alpha, and at what cost.

Source: The Future of Investment Management, Ronald N. Kahn, 2018 CFA Institute Research Foundation 

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