Usually a research process will define a group of managers who are all good at what they do within a particular sector or asset class.
The manager selection decision depends largely on which managers combine well and in what proportions in order to create the risk and return characteristics required in order to meet the client’s investment objectives.
When combining managers it is important to focus on understanding the risk/return drivers specific to each manager in order to make a reasonable estimate of how they will probably derive returns.
The key to reaching this understanding of risk is to recognise that risk is ultimately a qualitative, subjective and fluid concept. Various quantitative tools are used in exploring risk, but care must be taken not to fall into the trap of viewing risk as a series of numbers that are fact. Statistical risk is an indicator of actual risk, and often a rather vague one at that.
A good research process should aim to arrive at a stated level of conviction behind a recommendation.
The aim is therefore to identify a diverse range of investment approaches and managers that have differentiated sources of excess return to draw from. This should put a multi-manager in a position to harness as many different high conviction sources of excess returns within portfolios as are available.
Armed with choice, a good multi-manager can then effectively blend managers to achieve the best portfolio combination.
Characteristics in a reference index (style, size, sector, region) will deliver a return, but it will not always be positive so it is essential to blend managers to mitigate the impact of this volatility.
Returns associated with the manager’s skill should, by definition, be more persistent since they depend on inefficiencies that are not efficiently priced by the market.
In blending managers, we look for the most efficient combination of all these risk sources. The range of sophisticated quantitative risk systems at our disposal help us, but we also need an accurate qualitative understanding of the manager’s investment philosophy and process.
Of course, circumstances change as often as conditions in financial markets alter, and the style attributes and risks in a fund manager’s portfolio can change with it. This is why ongoing research and detailed monitoring of managers and their portfolios is essential for performance and risk over time.
Ensuring that an investment manager is financially stable, has the appropriate risk and compliance functions in place, and takes an appropriate approach to risk is essential. Therefore, good multi-managers must robustly kick the tyres of investment businesses in order to be clear that the investment team in question really do contribute to performance in the way that they said they do.
If, when selected, a manager offers a certain set of style characteristics, monitoring the exposures in their portfolios for different factors can prove insightful for early warning of changes in their approach and/or their contribution to risk. Understanding when characteristics in a portfolio are changing (and why) is critical, so adjustments to the weighting can be made to reflect this.
Nicholas Pothier is manager of HSBC open global return and open global distribution funds.