John Nash’s groundbreaking work in the area of “game theory” observed that the best result for a group often occurs when everyone making a decision takes into account the decision of others. This also holds true for portfolio construction decisions but whole-of-portfolio decisions are often difficult to implement in a multi-manager portfolio structure. How can one fund manager take into account the decisions of another fund manager when they are also in competition? As super funds demand greater value for money, fund managers will have to adapt and offer services in a completely different way to assist super funds, but there are also changes super funds can make to improve portfolio outcomes.
No matter how confident one is with an investment view, there is always the chance of being wrong, therefore diversification is a core part of managing portfolio risk. Accessing a broad array of return sources in a scalable and cost-effective manner is essential to building a portfolio where the risks are balanced and value for money outcomes are achieved for members.
Super funds with larger assets under management achieve economies of scale in areas such as administration, insurance arrangements and compliance. Negotiating lower fund manager fees is also typical with larger investment mandates. However, once super funds and fund managers reach a certain size, there are also challenges associated with scale such as over-diversification and the dilution of alpha. Unless an investment approach adapts it can be much more difficult to outperform at a larger size.
It is time to rethink the notion of how to improve ‘value for money’. We have seen funds co-investing alongside fund managers in asset classes such as infrastructure and property – scaling exposures to individual assets and benefiting from the fund manager’s deal access and due diligence process. Rather than thinking of an external manager as running a discrete pool of money, and net of fee alpha as being the sole measure of value for money, we should start to look at the insight generated by that manager and how it could be leveraged across the broader fund. Some investment ideas are very scalable (for example, global asset allocation views), whereas other investment ideas such as stock selection have capacity limits and potential issues with price impact.
Funds, if they are not already doing so, should be exploring ways of working with their external managers in order to capture good risk-adjusted investment ideas at the whole-of-portfolio level rather than having the impact of those ideas being limited to the amount of capital allocated to each manager.
Consider the diversification benefits of the following strategies which are sometimes overlooked or poorly sized in multi manager portfolios:
Strategy 1 – Separate alpha and beta
How much alpha you have in the portfolio should not be linked to your view on beta risk. Alpha is most easily found in inefficient areas of the market like emerging markets and small caps. Unfortunately, inefficient markets tend to have lower liquidity than larger more efficient markets, and are typically the most vulnerable in a “flight to quality” scenario. Instead of redeeming from emerging markets, small caps and Australian equities to protect the portfolio from a downturn in markets, designing a portfolio hedge via a swap or futures contract can remove the beta risk without diminishing alpha.
Strategy 2 – Monetise volatility
Options can be particularly useful when the market has been in a low volatile state for a period of time and complacency is high because the cost of options is typically low and the downside risk is the price of the option rather than the performance of the underlying market. The transition from a low volatile to high volatile environment can benefit options immensely. The most obvious way to protect the portfolio is to buy put options, but buying call options can also reduce risk. Call options can be a sensible substitute to holding equities when valuations are stretched but momentum is pushing prices higher. This strategy can help maintain participation in the latter stages of a bull market when the market prices can go parabolic, before reaching an exhaustion point.
Strategy 3 – Relative value opportunities
Being prepared to buy the less expensive markets with positive changes to economic conditions (eg accommodative monetary policy and fiscal stimulus) while avoiding, or underweighting, expensive markets where financial conditions are tightening is a sensible way to manage risk at transition points.
Strategy 4 – Use currencies as a shock absorber
Ideally, positions in foreign currency should not be linked to how much an investor is prepared to allocate to global equities. It should be a separate decision based on the best opportunities available. Currencies have been a rich, yet often over-looked, source of returns.
For example, the build-up of emerging market debt, and China’s difficult transition away from an investment driven economy, and the associated decline in commodity prices, has led investors to shun emerging markets exposures. One way to protect portfolios from a potential China hard landing or even slowdown is to short the RMB against the USD.
All of a super fund’s external managers are a potential source of insight into market opportunities, but assistance may be needed to distil and implement the best opportunities in the most efficient way.
Managing risk through the investment cycle requires a dynamic and flexible approach to portfolio construction. Ideally, as Super Funds became bigger they would develop a multi-disciplined team to build the core characteristics of the portfolio. The objective of directly managing the core of the portfolio is to:
- Control factor/style biases
- Reduce the overlap of unintended risks (improve diversification)
- Leverage ideas from external managers so that these ideas are sized appropriately to make a difference to the portfolio
- Improve portfolio efficiency (cost, information flow, and efficacy of implementation).
Many leading super funds are already implementing an integrated core portfolio approach while others are wondering how to get started. Before a fund commits to hiring a dedicated internal team we believe partnering with a fund manager as a sounding board and as a means of implementing ideas could be a prudent first step.
These partnerships could help solve scale and diversification problems, while transferring knowledge to the Fund as it builds its internal team. We believe when this happens achieving better value for money for members will take a giant leap forward.
Michael O’Dea is the head of multi asset at Perpetual Investments
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