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Value-added tracks

Over the last year, a new trend has emerged, with some of the UK&#39s major pension funds increasing the number of investment managers managing their funds. They are taking this action to reduce risk by diversifying management of their assets.

The reason behind this shift is that investing with a single manager involves a lot of risk or uncertainty about added value, no matter how good we think that manager is.

There is a way to reduce this risk and more and more pension funds are taking advantage of this opportunity.

To start, there are some important questions to ask. Which investment style will generate the highest returns? Is it managers focusing on companies with the strongest earnings&#39 growth; those looking for companies that are selling relatively cheaply; or perhaps managers focusing on small stocks will do best?

Even if we could figure out which investment style will generate the highest returns, we still need to know which investment manager to hire. In reality, we can be sure of neither the performance of investment styles nor individual managers. What we do know is that no single style or manager will do well in all time periods.

There is one basic way in which risk can be managed – diversification. Diversification is the foundation stone of modern portfolio theory. It is about putting more eggs into more baskets. The way to diversify the risks of underperformance of a single manager is to invest the portfolio into a combination of investment styles and managers.

By investing in a combination of complementary managers, uncertainty about added value may be reduced. When one manager underperforms, another may be doing well, especially if their investment styles differ. The result can be a more consistent value-added stream for portfolios using multiple managers.

Multi-manager strategies – of which manager of managers is an extremely efficient form – involve the hiring of a range of external managers. These external managers are often specialists in a particular asset class, and they have a particular and well defined investment style. Specialists maximise skill and value-adding ability (within their style) by concentrating their knowledge and resources in a narrow area.

Manager of managers&#39 approaches can be highly effective in reducing risk but the question remains of how many managers should be used. Eventually, the addition of more managers pushes a portfolio closer to the average in terms of both risk and return. The objective in constructing a manager of managers&#39 portfolio will be to reduce risk to the extent that this is possible without compromising expected returns.

The risk-minimising number of managers depends on two things:

•How efficient markets are – this is what determines how much value active managers can add and is dependent on a number of things, for example, improvements in the speed at which information is disseminated.

•The extent to which managers hug the benchmark – if managers stay close to benchmarks they limit their value-added potential. By having the courage of their convictions, value-added potential can be increased.

The various providers of manager of managers&#39 port-folios invariably have different views on how efficient markets are, not least, because of the unique design of manager mandates.

Mandates define what the manager&#39s objective is and it outlines how this objective is to be achieved. A focus on short-term performance versus benchmarks reduces a manager&#39s ability to add value. By encouraging managers to rely more on their investment insights to position the portfolios and less on benchmarks, expected added value can be increased.

It is also important to explore how many stocks maximise diversification benefits. More stocks will tend to reduce risk versus the benchmark but may also compromise added-value potential. A strong focus on reducing the potential for underperformance versus the benchmark may not be in the interests of investors. Managers should exclude rather than underweight unattractive stocks.

By staying close to benchmarks, managers are managing their own rather than investors&#39 risk. Higher-conviction portfolios allow managers greater freedom to use their investment insights to add value – the higher the level of conviction, the lower is the importance of the benchmark. Higher-conviction or concentrated portfolios zero-weight unattractive investments. As a result, they often have fewer stocks than is typical.

At its best, the manager of managers&#39 approach can help managers unlock themselves from benchmarks and ultimately increase value-added potential. Moving away from the benchmark involves more uncertainty about added value but, by increasing the number of managers, this higher-conviction approach need not raise risk levels for investors.

Big pension funds have the scale and capacity to research, employ and monitor the services of several managers and enjoy the benefits of this diversification of risk but for financial advisers this level of resources is not an option.

It is not simply the task of choosing different funds in different sectors as a means of diversifying a client&#39s portfolio – we could all feasibly do that.

More important, it is researching managers, monitoring their performance reg- ularly, changing them when necessary, and monitoring the whole portfolio daily to ensure the asset balance is maintained and attitudes towards risk preserved.

Employing a manager of managers&#39 approach means that advisers can offer investors the benefits afforded by big pension funds and institutions but without burdening themselves with the task of constructing and managing such portfolios.

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