More performance and less risk

In sports, you often find one or two established teams may dominate for extended periods of time, seemingly impenetrable to smaller teams. Sometimes, though, while the established teams are content with the “if it isn’t broke, don’t fix it” mentality, other teams are busy finding new ways of improving performance.

In any case, the older legs of the top teams eventually tire and a fresher team suddenly appears, apparently out of nowhere. Why wasn’t this team spotted before? In many cases, it was because the larger teams were more well known and easy for journalists to write about, while nobody did the research required to understand the smaller team. This is much the same in the investment world.

We have seen an increasing trend for multi-managers and pension funds to increase allocations to specialist funds, as a way of increasing their alpha generation. It would be safe to say that intermediaries and retail investors would like to follow suit, but the biggest hurdles for these groups to overcome are restricted access and limited information. I will touch on these shortly, but I should first define what I mean by “specialist” funds.

I am not talking only of boutiques, but also some larger fund management groups; Merrill Lynch is in this category, particularly with Mark Lyttleton’s UK Dynamic fund. Fitting more in the boutique category of specialists are Artemis, Odey and Thames River Capital, either for specific funds (such as Adrian Paterson’s Artemis UK Growth) or a particular expertise (Thames River’s total return capabilities).

What makes a fund “specialist” is not the size of the firm, but instead the flexibility of the fund. Typically, specialist funds are not benchmark-sensitive, which enables them to outperform potentially in all market conditions. In strong bull markets (1990s), the managers can move into higher-growth areas. In big bear markets (2000-2003), they can move more defensively. In choppy, non-trending markets (today), they can move in and out of areas more actively than traditional funds.

However, specialist funds do not have to be concentrated in a relative handful of high-alpha stocks, although many are. Nor do they have to be small in size, although in some cases this can be an advantage. To qualify, in my mind, they just have to be flexible and active enough to take positions ahead of the cycle (or at least soon into it). To accomplish this, they must have the freedom to act on their convictions, even when the rest of the market is forced to take contradictory positions, possibly because of strict benchmark ties. Benchmark constraints are put in place normally as a means of controlling relative risk, but too often they can limit performance or force portfolio managers to make real losses.

For too long, specialist funds have been pushed to the periphery of portfolios – to the extent that their contribution has been limited. My argument is that if you believe a fund is well managed, the manager is skilled in picking stocks and the manager’s process and philosophy are sound, then what is the value of holding an insignificant amount of that fund? Do managers hold the fund because they genuinely believe in it or simply because they fear being wrong?

In most diversified portfolios, the “core” holdings are typically larger, traditional funds or mandates, with relative performance targets (either relative to an index or peer group). This means the overall performance target is a marginal outperformance of the benchmark. I would stress that this target is quite reasonable for many portfolios. However, for those wanting the potential for higher performance, investors need a way of bringing specialist funds to the core, but without increasing overall risk.

Multi-managers can provide retail investors access to specialist funds in a risk-controlled vehicle. Importantly, multi- managers can ensure the inclusion of such specialist funds is balanced between the added performance potential and the risk to the overall portfolio. In many cases, we have found that replacing an average general fund (one with a low tracking error, for instance) with a specialist fund can actually improve the risk-adjusted return of the portfolio.

Referring back to the hurdle I mentioned earlier, retail investors rarely have the opportunity to speak to fund managers, especially those from boutiques that do not have the marketing budgets. Retail investors also cannot gain access to institutional managers, such as GMO Woolley, which has excellent equity capabilities.

When specialist funds are available, in-depth information is often limited. How then can an investor make a truly educated decision? Most intermediaries would not even have access to much more information on these managers. For example, Taube Hodson Stonex and Edinburgh Partners are two specialist boutiques, but what does the intermediary market know about them? If an investor does notice a specialist fund at the top of a published league table, and invests on the back of this, they may be unwittingly exposed to too much risk.

Multi-managers can access retail and institutional managers alike, speaking to management teams and discovering how the investment and business are run. Through in-depth analysis, incorporating such tools as style and combination modelling, multi-managers can determine what a specialist fund’s inclusion would do to the portfolio’s overall risk and return characteristics. The aim is to derive the most potential from each component.

I believe specialist funds play an important role in multi-managed portfolios, but the multi-manager must have the appropriate tools and expertise to provide investors with the benefit of increased performance without having to increase the risk. In this regard, active multi-managers can ensure that investors are not left holding the wooden spoon.

JAMES HUGHES
portfolio manager at Axa Investment Managers