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Multi-manager View: Full to capacity

One of the frustrations in fund management is when a promising fund manager loses momentum and the success with a small fund gives way to mediocrity after strong asset growth. Sometimes this is ascribed to cashflow issues but sometimes the problem is more permanent, the process has simply run out of capacity.

In fact, all investment approaches have a finite capacity to add value. Understanding where this limit stands is fundamental to a multi-manager strategy and its existence is increasingly influential on the strategies of managers.

The problem with managers seeking returns beyond the capacity of their approach or at a level greater than can be provided by it is that they experience increased risk relative to the benchmark but do not see the expected return. Information ratios fall but spotting the true cause of the problem in the barrage of data that investment markets can produce is very difficult.

From the fund manager perspective, optimising the profit on available capacity is obviously essential and many look to achieve steady long-term returns from key clients, with profitability spiced up by some exposure to higher margin products. In this context, the high alpha fund can be a double-edged sword for investors. The increased risk exposure can be taken as a given but will the extra return be there? If capacity is constrained, at whose expense will the “additional” alpha be provided? All other things being equal, it can only mean a reduced share for existing investors.

Determining where limits lie is made more difficult by the problems that some managers face in determining the contribution to their returns attributable to alpha and beta exposures. Understanding this confusion helps explain some of the performance phenomena we see. What happens is that, having established a benchmark or created an expected area of focus and specialisation rather than bet their skills within the market or segment, the managers bet against it. Sometimes, of course, these beta exposures are taken on willingly because they are the only way to achieve targets – the market environment can be simply too efficient.

Why are beta exposures important? It is because of what they do to the risk of the fund. Investors can reasonably expect the fund to follow the path implied by the labelling but significant non-benchmark exposures can frustrate that. This is one reason for the volatility of individual fund rankings in the peer group tables.

The position is more complex in a multi-manager environment because poor control at the fund level can impact on the overall risk profile of the fund. For those multi-managers who try to find specialists for each niche of the market, errant fund managers have committed the sin of style drift. Our view is that asset allocation control is our responsibility, just as asset allocation choice belongs with the IFA. We therefore spend a good deal of time identifying funds with these characteristics – and avoid them.

In order to maintain reasonable alpha expectations, what one can do is look at risk budget management at a strategic level and rein back the allocation to areas where the likely prospect of excess returns are low and instead make it available in markets of greater promise.

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