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At first glance, the business of running a multi-manager fund would appear straightforward – find the best investment managers and put them together in the same portfolio. Such an assembly of stars would seem to guarantee outperformance. But it is far from that simple.

Multi-manager analysis must not be confined solely to an assessment of whether a fund is well managed. It is equally important to determine how the fund fits with other holdings in the portfolio. You need to find funds which complement each other rather than clash. Get the right mix and you can achieve better returns at lower risk.

Obviously, we need volatility to achieve our target returns. But within our own funds, we would like to achieve these returns with less volatility rather than more. Reduction in risk can be obtained through an appropriate mix of funds. As we add more funds with a low correlation, so volatility will fall.

But this process does have its limits. Here is an example. Building a simple UK equity portfolio for a client might involve identifying top-performing managers, doing the due diligence and coming up with a short list of three. Let us say that on that short list are Artemis UK special situations, Framlington UK select opportunities and Fidelity special situations.

While there are clearly some similarities shared by all three funds, there are also many differences in the way they are run and in the nature of the fund groups. So how much diversification is achieved? Despite differences in holdings, the funds have performed in a remarkably similar fashion over the past year, posting strong numbers in January and being weak in July. In effect, they are performing like one fund.

This example of correlation means we are less diversified than we might think. This leads to some interesting questions. Should we use just one of these funds or all three? If we use three, is this inefficient? Should we have the conviction to go with just one name? If we do use just one name, is that too much risk? It is possible that this correlated performance may end if one of the managers goes off the boil. If we hold only one fund, then we may be lucky – the performance problems may occur in the two funds, not in the portfolio. On the other hand, we may not be lucky.

In theory, there are two reasons why the volatility of a portfolio can fall when you combine funds. The first is that you are mixing generally different and relatively uncorrelated assets, so achieving diversification. The second is that you are simply adding a lower-volatility asset to the mix. This merely dilutes active exposures with no diversification. It is definitely not a good solution because you are reducing your ability to add value.

Our goal is obviously to reduce risk while maintaining the alpha exposure in a portfolio. Sadly, there are many examples where the trade-off between risk and return is not efficient. Some manager of manager products built up from underlying institutional-type mandates fail to offer the sort of high-alpha managers you find in the retail market. When coupled with high costs, this structure could be programmed to disappoint.

So it is vital to looked inside a fund. Unless you the know the process behind a particular fund and its holdings in detail, it is not possible to know whether the mix of funds in your portfolio is delivering genuine alpha or merely diluting returns.

Richard Skelt runs Fidelity Investments&#39 multi-manager and fund of funds portfolios


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