When advisors pick managers and strategies, and when advisors and investors assess performance, it’s important to remember that size matters. We understand this implicitly when it comes to the asset allocation exercise because we are inherently making bets (or not) against cap-weighted market sectors. But we often forget it when it comes to manager selection and performance attribution.
Consider a client’s US large cap stock allocation, which might be, let’s say, 20% of the total portfolio. We might implement this allocation as follows:
* 50% (that is, 50% of the 20%) to a passive, tax-aware manager.(1)
* 40% to a value-oriented manager selected because we feel the market is over-valued.
* 10% to a highly concentrated manager, probably a hedge fund, focused on a market sector where (we believe) the manager has significant skill.
It’s hard to know in the abstract whether the sizing of the allocations to these managers is right or wrong, but in the context of specific client portfolios we should know. I would suggest, for example, that the above allocation is appropriate for an experienced, sophisticated client. A client with a lower tolerance for risk should probably have a higher exposure to the passive manager, a lower exposure to the value manager, and no exposure at all to the hedge fund. A great deal will depend on the volatility of the value manager versus the sector benchmark.
Or consider the sizing issue in the hedge portfolio(2). Many investors will have a core position in hedge funds of funds,(3) supplemented by individual hedge funds in which the investor (or, more likely, the advisor) has great confidence. How to size the funds of funds versus the individual funds?
Let’s say that the hedge fund allocation is also going to be 20% and that we are going to use one fund of funds and two individual hedge funds. Suppose the fund of funds uses twenty managers. Each of those managers would, on average, have 5% of the overall fund of funds, or 1% of the overall portfolio. Should we also size our individual hedge funds picks at 1%? Probably not. A 1% position is just noise in a portfolio, and if we don’t have more confidence in the individual hedge fund we probably shouldn’t be using it.
What about a 5% position, representing one-quarter of the 20% total? This probably makes more sense, but it raises the possibility of erratic performance against the benchmark. In other words, many individual hedge funds that outperform over time tend to generate very inconsistent performance quarter-in and quarter-out.(4) So, again, the question comes down to the experience and sophistication of the investor: can the client tolerate inconsistent but generally good performance, or is the client likely to lose faith in the manager at the wrong time?
Size also matters when it comes to performance attribution. Let’s look at the first example, above, where we allocated the large cap sector to three managers: a passive, tax-aware manager, a value-oriented manager, and a highly concentrated hedge fund manager. In this particular quarter, the investor underperformed the S&P 500 Index, even though both the passive manager and the hedge fund beat their benchmarks. The problem was that the value manager didn’t, and that manager had 40% of the sector allocation. If this happens a lot, we might find that we have over-allocated to the value manager relative to our actual level of confidence in its ability to outperform. Perhaps we should revisit the manager breakdown.
The bottom line is that sizing allocations to managers, and paying attention to size when assessing performance, are necessary aspects of successful portfolio management. In the world of investment management, size matters.
(1) A passive, tax-aware manager is one that tries to meet the performance of its benchmark – in this case probably the S&P 500 or Russell 1000 – while exceeding the benchmark return on a net-of-tax basis. The manager will constantly be realizing short-term losses that occur via natural market fluctuation and “banking” them to be used later to offset taxable gains.
(2) Even in a portfolio where long/short managers are slotted into traditionally long asset classes (like US large cap, as in the example above), most investors will also have an allocation to hedge funds that are less well-correlated to long benchmarks. These might be global macro managers, event-driven managers, very low net managers, and so on. We create a separate allocation not because we believe these funds to constitute an “asset class,” but because we don’t have anywhere else to put them, given the limitations of the asset allocation exercise.
(3) This isn’t the place to deal with the loathing many investors have for funds of funds. I will merely note that the hostility is warranted in general but self-destructive when taken to an extreme.
(4) That is, inconsistent relative to such benchmarks as the HFRI or a long-only index like the S&P 500.
Next up: How Not to Adjust Your Asset Allocation
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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.