Multi-managers embrace a new dynamism

Multi-managers feel the increasing sophistication of their investment approach is making it less of a challenge to demonstrate that they can deliver enough active return to justify the fees they charge, writes Caroline Munro.

A rebounding market following the global financial crisis (GFC) saw multi-managers outperform their single manager counterparts. But considering the latest Lonsec Multi-Sector Review 2010, this may have had more to do with their inflexible rebalancing policies.

Lonsec noted that single manager diversified funds employing tactical asset allocation (TAA) outperformed multi-managers during the global financial crisis because of their ability to underweight equity market exposures.

However, multi-managers did better in the upturn as they remained fully invested in equities while single managers were slow to add risk.

It seems that multi-managers have recognised some of the downsides of their approach and a recent trend is a shift away from the strategic asset allocation (SAA) adopted by most multi-managers to a more medium-term approach termed dynamic asset allocation (DAA).

Mercer’s head of investment management in Australia and New Zealand, Gary Burke, agrees that the challenge for a multi-manager is demonstrating whether they can deliver enough active return to justify their fees.

“But they’ve become much more scientific in the way they’ve gone about building portfolios,” he says.

“The science of multi-manager investing has gone ahead by leaps and bounds in the last five years, and investors are going to benefit from that increasingly sophisticated approach to building a multi-manager portfolio.”

In Lonsec’s sector review, researchers Deanne Fuller and Duncan Knight pointed out that the DAA approach is relatively untested, and therefore they have not undertaken a full assessment.

However, Mercer and Intech have been using the approach for a number of years now, while Russell Investments and MLC have introduced it over the last year.

Sean Henaghan, director of AMP Capital Investors multi-manager investment platform Future Directions Funds, says that while DAA is a good idea, it’s not as easy as it sounds.

He says the effectiveness of active management demands breadth and skill.

“If you can make a lot of decisions, skill becomes more obvious,” he says. “With DAA you’re actually not making a lot of decisions and so it’s quite difficult to figure out whether you’re actually good at it or not.”

He says while they believe in the value of DAA, Future Directions Funds will only spend 10 per cent to 15 per cent of the risk budget on that approach, adding that it’s against the multi-manager approach to have the risk profile dominated by a single manager.

“You go to multi-managers because you want diversification. If we start taking asset allocation bets, the returns are going to be driven by those bets,” he says.

Burke says Mercer has always believed that the strategic benchmark reflects long-term assumptions about market behaviour.

“But in the short to medium-term it makes sense to make adjustments as valuations or risk assessments warrant it,” he adds.

“Therefore, it’s prudent to take some positions over the medium-term, particularly those that will protect investors’ capital.

“It’s not a TAA approach, but it’s more in line with the standpoint that the assumptions that are reflected in your long-term strategic benchmark don’t always prevail over shorter time periods.

"Rather than following the lemmings over the cliff, it makes sense to adjust those asset allocations as circumstances and risk assessments warrant.”

Burke adds that Mercer tends to take only small positions within a fund.

“We’re not trying to bet the farm — these are only incremental adjustments to protect capital at the margin rather than throwing the asset allocation off kilter.”

Advance Asset Management’s Patrick Farrell says Advance has been practicing DAA for some time and this is a good trend going forward as volatility increases.

“Equity risk premiums have and are going to increase, and from a DAA point of view it’s a good thing because sometimes you need to be able to get in and out of the market — not totally, but you need to adapt the portfolio when needed,” Farrell says.

Select Asset Management’s Dominic McCormick says the move towards DAA is recognition of the flaws in the ‘set-and-forget’ SAA approach.

“You are starting to see people realise that some of the assumptions that go into determining a long-term SAA aren’t very valid,” he says. “Risk changes over time, and volatility in itself is not a very good measure of risk.”

McCormick says no one has ever been able to give him a definition of what SAA actually is.

“We’ve never believed in having a set-and-forget SAA mix because I don’t think there is one in which you can be confident it will meet your objectives over time,” he says.

McCormick says that while the majority of multi-managers are still using the SAA approach, more are reviewing what they do and taking the steps towards a more flexible approach.

The Lonsec sector review revealed that some multi-managers are looking towards different approaches, and stated that Advance, AMP, BT and United are some of the multi-managers that have been using specialised ‘global’ TAA managers to exploit short-term market inefficiencies across a much broader range of smaller decisions, such as asset classes, countries, and currencies.

McCormick says the investment environment going forward will mean that multi-managers need a more flexible asset allocation approach that will also be capable of adding value.

“There are more resources and quality people being put in place in multi-managers and you will potentially see added value from some of the better multi-managers, partly because they’re moving away from selecting benchmark managers to more concentrated managers,” he says.

“I think that gives them the ability to outperform a broader index over time. It certainly won’t show over all periods.”

The Lonsec research found that most multi-managers acknowledge that short-term inefficiencies do exist in markets, but they do not believe that the TAA approach can solve the problem.

The TAA approach demands large bets across a limited asset class range to deliver significant alpha.

“This requires a large amount of skill, which many multi-managers concede they do not have,” the research paper stated.

MLC investment manager Susan Gosling says MLC does not believe in TAA as “your short-term outcomes are all over the place”.

“We don’t think that’s a sensible approach because there are too many variables,” she says, adding that MLC prefers to focus on fundamentals and adapting to possible scenarios as opposed to taking bets.

Russell Investments’ chief investment officer for Australasia, Symon Parish, says they also have an aversion to TAA.

“There’s this kind of compulsion to be doing something all the time, but you should only have that position in place if you have a lot of conviction around why you’re doing it,” Parish says.

Manager selection vs asset allocation

Industry commentators have noted a shift in focus from manager selection to asset allocation. AMP Capital Investors’ head of investments strategy and chief economist, Shane Oliver, states that in the 1990s asset allocation took a backseat because of an environment of high real returns.

However, he says this is shifting due to a more constrained investment outlook.

“This means anything that can improve returns — including asset allocation — will be far more valuable than when average returns are much higher,” he wrote in a recent Oliver Insights market report.

“If economic and investment cycles are becoming shorter and more extreme, correlations between equities and bonds remain negative and medium-term investment returns are more constrained, then this will provide more opportunities for shifts in the allocation between key assets to enhance the returns investors receive,” Oliver added.

McCormick says manager selection was more important in the SAA approach because it was really the only thing multi-managers were doing, apart from reviewing the asset allocation every three years or so.

He says recognition of the flaws in the SAA approach and the need to become more dynamic and flexible entails that asset allocation is more important on an ongoing basis.

“It’s not saying that you are doing less in terms of manager selection, but I think it is basically saying that asset allocation is something that there needs to be more of a focus on, rather than just at the beginning in setting up a long-term asset allocation,” McCormick says.

Gosling says MLC’s viewpoint bucks the trend, even if stock selection is relatively more important due to suppressed returns.

“In the environment that we’re in, giving managers the discretion to move away from the benchmark and invest in companies that they believe can generate a good medium-term real return may be the key, more than diddling with the asset allocation,” she says.

Mercer recently won the Money Management/Lonsec Fund Manager of the Year Multi-Sector award, and Burke says that selecting the next generation of best of breed managers is key to success.

He adds that manager selection comes down to research and the ability to pick the winners from the losers.

“Picking fund managers is like picking stocks, although it’s a highly concentrated bet,” he says. “You have to make sure you have the right ones in your portfolio, otherwise performance is going to suffer.”

Lonsec noted in its sector review that with the exception of Advance and ING Optimix, the majority of multi-managers failed to add value in manager selection over the three years to September 2009.

“This is extremely disappointing given that the primary function of a multi-manager is to select and blend quality underlying managers,” it stated.

McCormick says while you have to be careful extrapolating this kind of historical data, the findings highlight that the quality of people and the experience needed in selecting managers is all important.

He feels that until recently there has not been a lot of effort focused on multi-manager teams and employing talented investment people.

Parish says the disappointing performance over 2008 was partly as a result of multi-managers favouring higher risk managers.

“The whole principle of multi-managers is that you can take more risk at a single manager level and, because you are diversifying it in that multi-manager structure, you can still deliver a level of risk that the investor is comfortable with,” Parish says.

He says this was not the right investment strategy in the extreme market conditions that ensued, however, it did lead to strong performance in 2009.

Farrell says another issue that may have contributed to disappointing performance was a constrained ability to manage risk.

“I think there was a trend to actually increase the number of managers that multi-managers had under their profile.

"Even if it’s separating out these mandates into specific sectors, what the GFC has shown is that if you had a specific sector-based approach to the way that you allocated risk, you were taking away the risk management capability that those managers would have been able to provide if they had a broader-based mandate,” he says.

Concentrated mandates

Lonsec stated that a trend over the last few years has been multi-managers awarding more concentrated and/or higher alpha mandates. It noted that multi-managers have not opted for greater diversification and lower risk mandates despite increased market volatility in 2008-09.

Parish says this trend picked up ahead of the crisis because at that stage it was very hard to add value in such a benign environment.

“There wasn’t a lot of volatility or a cross section of volatility, where particular stocks or sectors performed differently to each other,” he says. “That’s the stuff that managers need in order to beat the benchmark.”

He says the result was a trend towards more concentrated portfolios where they would take more risk to get the same alpha that they used to get, but it did not turn out the way they had hoped.

He says Russell Investments researched what was the real issue — whether the problem lay in the actual concentrated style of the manager or whether it was the managers that were sticking to a core diversified style but using an add-on concentrated product.

He says it was the latter group that did not do well.

“Concentration in itself can be fine but we think it’s very important to understand the process that the manager is undertaking and whether it is suited to being run in a concentrated portfolio, because it’s not just a foregone conclusion that it will work better,” Parish says.

He expects the status quo of more concentrated mandates to continue, although there will be a lot more scrutiny as to whether concentrated mandates will add more value while adding more risk.

Farrell says higher risk mandates or allowing managers to be less benchmark aware suits the current environment.

“In a period of volatility, that actually creates a lot of short-term opportunity,” he says, adding that being able to trade in and out of certain positions to make the most of volatility with a high conviction mandate means they can really take advantage of stock dispersion.

“In the period up to 2007 stock dispersion was quite low,” Farrell says.

“Now, as regulation and a lot of the global dynamics affect companies in a different way, returns will be substantially different. You’ll get stocks that absolutely shoot the lights out and others that are really going to languish. This is an active manager’s paradise.”

Burke says, in the current market environment, Mercer has a preference for high quality, higher conviction managers.

“The problem for a multi-manager is not too much risk — it’s how to create enough risk to generate the necessary level of active return,” he says.

“It is such a risk-averse process that if you blend together traditional, standalone portfolios you are simply regressing to an index-type return.

"The better portfolio building blocks are the concentrated, higher tracking error portfolios because when you blend them together you get sufficient risk mitigation by the way in which you combine managers that are not perfectly correlated with each other.”

He says the trend towards more concentrated, higher alpha mandates is a positive one and will enable multi-managers to generate better active returns for their investors.

Alternatives

Lonsec notes that the size of investment teams has grown substantially in recent years, from an average of 5.6 people in 2006 to 9.3 in 2009.

The reasons for additional resourcing were increased competitiveness across the sector, wider beta opportunity sets or new asset classes and the research intensiveness of alternative assets.

Farrell agrees that alternatives can demand greater resources.

“Going into a lot of alternative assets carries with it a lot of baggage around the level of transparency that you get, their liquidity and how that asset class reacts with the traditional asset classes as well,” he says.

“We’re exploring different ways of accessing alternative assets to cope with that sort of baggage.”

Parish says Russell Investments has also increased its resources in the alternatives space.

“After having deliberately sat on the sidelines during the financial crisis, we allocated money into liquid alternatives starting late last year,” he says.

McCormick says the increased interest in alternatives has been a trend at some of the more progressive institutional multi-manager funds, rather than those offered in the retail space.

“But that is something that is certainly changing more recently,” he says.

“I think the case for alternatives took a hit in 2008, particularly some of the less liquid alternatives. But I think the broader case for alternatives has got through that period pretty well.

"I think there is still a desire to diversify portfolios — multi-manager and non multi-manager portfolios — and a significant weighting towards alternatives is an important part of building better diversification.”

Gosling says true alternatives are very rare but managers are looking at investing in the same old assets, although in a different way.

“Another way of thinking about alternatives is not just alternative assets but alternative strategies,” she says, adding that they are foregoing the concept of a market benchmark and looking at a real return outcome.

“What you are doing is investing much more in manager skill,” she says. “Your ability to pick the right manager is critical.”

Burke says there is an increased focus on genuine alternatives, which are non-traditional, listed market exposures.

“But the way alternatives allocation is invested varies markedly from manager to manager,” he says.

“I think in general, if you look at non-traditional market exposures or what you call alternative beta exposures (markets that deliver a return that’s not reflected in traditional listed markets), then that makes sense. It offers better portfolio diversification and risk management.”

Farrell says the increased interest in alternatives again harks back to constrained returns in the current environment.

“You have to have an asset allocation profile that is cognisant of the lower levels of return that are coming out of the more traditional asset classes, which is probably why people are moving more towards alternative asset classes to try and generate skill-based returns,” he says.