As the trend towards multi-manager/fund has gathered pace, there has been a premium on experienced teams with the ‘skills’ to run these types of mandates. Perhaps the answer is a multi-multi/manager of manager of manager facility?
The principles that underpin multi-manager have been with us for many years and are the same principles that gave birth to the IFA industry. They include choice within a free market and diversification, i.e. not putting all your eggs in one basket. In the late 1990s, Frank Russell turned multi-manager into a structured proposition, claiming it provided diversification of assets, diversification of style and embedded alpha. The proposition will, perhaps, be best remembered for its comparison between the performance of the Sydney Olympic gold medal-winning decathlete and the individual performances of the gold medallists in each of the separate disciplines. Under the slogan “no one is best at everything”, Frank Russell implied that if you pick the ‘best’ in each sector, you will improve results.
It was a good sales pitch and the concept took off under various guises, including multi-fund, multi-manager, fund of funds, fund of hedge funds and so on. Sadly, there is often an inverse relationship between the popularity of an investment trend and the accuracy of its claims (which is why we get ‘bubbles’) – and multi-manager is no different. Most of the principles that underpin it are fallacious and its acolytes misguided.
In 1991, Nobel Peace Prize-winning economist William Sharpe wrote a piece called The Arithmetic of Active Management. In the article, Sharpe asserted that “After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar”. This is intuitively true because the combined returns (before costs) of all investors in a market must be equal to the actual return from the market. On the whole, active managers carry higher costs than passive managers because active managers trade more (which increases dealing expenses), pay for research and levy a higher management fee. As a result, they underperform.
Studies
In 2000, Roger Ibbotson and Paul Kaplan published a paper entitled Does Asset Allocation Policy Explain 40, 90 or 100 Percent of Performance? The paper was intended to clear up a misconception that had arisen based on a study by Gary Brinson, L Randolph Hood and Gilbert Beebower that showed 90% of the variability of a portfolio’s performance over time is the result of asset allocation policy. This was incorrectly misinterpreted as indicating 90% of the return from a portfolio can be attributed to asset allocation, and Ibbotson and Kaplan sought to set the record straight. Part of their work included measuring the part of the actual returns from portfolios that can be attributed to asset allocation. This was calculated as the ratio of the annual benchmark return divided by the annual return. A fund that invested exactly in accordance with its benchmark would have a ratio of one as the returns would be the same. A fund that outperformed its benchmark would have a ratio of less than one, and a fund that underperformed a ratio of greater than one. In practice, the average ratio was higher than one, which means over 100% of the funds’ returns can be attributed to asset allocation. The extent to which it underperforms will be determined by cost – ergo, it is better to cut cost than seek alpha.
Some advocates of multi-manager (and by multi-manager I mean either the packaged proposition or the IFA that selects from several different groups) will quote the successful consistency of returns from some well-known star investors as defence of their art. I cannot, of course, argue against the evidence of the superb track records of individuals like Anthony Bolton and Neil Woodford, although mathematically, they could just be two of the luckiest investors ever. But even if you attribute the track record of star managers to skill, can you spot them in advance? Trying to do so is a risky business and the number of so-called ‘rising stars’ that crash and burn far out-number those like Bolton and Woodford who deliver outperformance over two decades. And even if you do find, and stick with, a rising star be careful – if they leave, you may just get trampled in the stampede as investors head for the exit.
Arguments
Another argument for multi-fund/multi-manager collectives is that you do not need to swap ‘wraps’ if your favourite star manager changes companies, thus triggering a potential chargeable event (assuming you are lucky enough to have made profits). With multi-fund/manager, the provider argues that because the change of investment group occurs within the wrap, the holder is protected from any adverse tax consequences. Further, the investor does not have to worry with the administrative hassle of changing companies. That is all very well, provided the multi-manager/fund team stay in place, but that is not happening. As the trend towards multi-manager/fund has gathered pace, there has been a premium on experienced teams with the ‘skills’ to run these types of mandates and they have been moving to the highest bidder. Perhaps the answer is a multi-multi/manager of manager of manager facility?
Whichever way you look at it, it is much more sensible to concentrate on executing your client’s chosen asset allocation at as low a cost as possible. Packaged multi-manager does exactly the opposite by double stacking charges (or triple stacking if you include the advice from the IFA). The FSA has obviously been doing its homework and reached similar conclusions. Its June 2009 review under the section “A new standard for independence” makes frequent reference to ETFs which are, of course, a passive low-cost method of executing a client’s asset allocation policy.
Multi-manager is a good story and it does at least provide a method of implementing asset allocation and diversifying risk, but these can be achieved in a more efficient, lower-cost fashion. The arguments against active management are irrefutable as Sharpe, Ibbotson, Kaplan, Brinson, et al, have proved. But even if multi-manager does side-step the logic, at least for the present, it will be clubbed to death by the FSA under RDR. There are much more efficient methods of implementing asset allocation available in the broader marketplace (ETFs and derivatives under Ucits III to name but two) and the FSA is well aware of them.
Gary Reynolds, director and chief investment officer, Courtiers
