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Managing the managers

The manager-of-managers approach to investment has attracted a great deal of attention and a large number of new entrants over the past few months. It is a must-have for an increasing number of fund management houses.

Done properly, there is no doubt that a manager-of-managers strategy can add rare value to investors by providing superior performance and reducing relative risk. The portfolio can be built so that it works hard through different parts of the cycle without falling foul of failing fashions.

But just because this model can deliver does not mean that it will. It certainly does not mean that the approach gives easy access to added value.

However attractive the label, it is the process and how it is applied that counts. Unfortunately, this is not a world where quick fixes lend themselves to quick wins. In fact, all they lead to is unexpected risk and disappointment for the client.

When constructing a manager-of-managers model, the problem is not finding managers that have done well in the past or even those that might do well in the future. It is about finding those with skills and process which give them a chance of doing well consistently and those who can be combined with other managers to give a range of opportunities without additional risks. The task is to provide clients with true diversification and not simply a hidden layer of costs.

A major problem for the industry is that the theoretical accuracy of the models underlying much of the risk monitoring is challenged by dayto-day reality.

Consider multi-factor models which are designed to track contributions to risk and return from the various characteristics of a stock, for example, how much of past movement is explained by sector, size, price momentum and so on. In theory, the effect of these factors is distinct and separate but in reality they blur.

Look for a moment at just two factors – big companies and oil companies. Most oil companies are big but not all big companies are oil companies. When both factors move in the same direction, how can a manager be certain which to attribute the move to? Uncertainty creeps in and predictability declines.

This is with just two factors. In reality, a global manager will have at least 15 to consider. Controlling this number of complex variables is simply beyond managers using traditional techniques. This is not to say that judgement and tradition have no value – far from it – but it does mean that an investor will not be able to specify the risks he would like the manager to take.

There are problems of access, too. Risk control systems – good ones at least – are not cheap, nor are the skills required to run them. This means that an aspiration to manage a manager-of-managers service could be frustrated either by skill shortages or by simple economics. Another problem is that although the concept might be sexy, the underlying processes are not. They are complex, opaque and costly to run. Trying to explain them simply creates challenges in the retail sector.

This can lead to short cuts and unsound practices. One of the more popular short cuts is to pair value and growth managers. These are the groupings which are best supported by index providers and lend themselves to straightforward classification from published accounts data. The expectation is that, paired together, a value manager and a growth manager will combine to produce a balanced, lower-risk portfolio. This is a flawed approach.

The most important weakness of this is that value and growth are simply descriptions. Neither grouping is stable and both will be materially impacted by price and balance sheet events.

For example, consider a carefully constructed value portfolio, balanced in risk terms by a list of growth stocks. The value holdings perform well and rise to the point where a number of the criteria used to select them are no longer compelling. At this point, the portfolio is out of balance because the value bias has gone but the growth bets remain.

Should the value manager be obliged to sell? Should they be criticised for breaching their value guidelines by holding growth stocks – the sin of style drift? They will want to hold on to the winning stocks but, if they do, what happens to overall portfolio risk?

Sectors move over time from value to growth and back again. There is little sense in closing large parts of the market to a manager because of a sector rating. Why limit their ability to add value and why incur costs by following sector changes?

It is also debatable whether there are merits in chasing style. If we look at the returns from different styles, we see that all too often returns owe more to the geared approach to a particular segment of the market than to any skill from the manager in selecting stocks.

To meet expectations, a manager of managers has to fulfil twin objectives – adding value and controlling risk. Risk control must be achieved at two levels – first, within sub-fund portfolios, where risk is generated by the choices of individual fund managers, and, second, at an overall fund level, where risk reflects the aggregate choices of all fund managers.

This is far from simple and, because of the complexity, some are tempted to adopt a crude approach, imposing limits on stock or sector weightings. This can crowd out managers and limit return potential, for example, where a manager is unable to apply a good stock idea in a particular sector because the overall sector limit has been reached as a result of other holdings.

Risk controls have to be both subtle and secure – subtle so as not to limit opportunities for performance and secure because unexpected risk exposures are unacceptable. A sensible way to achieve this is to find top-quality managers who generate returns from factors which are complementary to each other. Each manager is given a risk budget which they can allocate as they wish but which they cannot overspend. Daily scrutiny ensures that the rules are followed. By allocating risk budgets to fund managers wisely, a manager of managers can ensure that overall portfolio risk tolerances are respected.

Applied successfully, this style reduces risk because of diversification benefits, while allowing excess returns to be achieved.

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