The perils of backing one horse

One of the most common mistakes in active equity portfolios is a failure to diversify across managers, writes Willis Towers Watson’s Leslie Mao.

There are many reasons why investors are not getting the most out of their active portfolios. This could be due to having a large home-bias, imposing constraints or not letting their active managers take enough risk.

However, the most common mistake we have observed is the lack of diversification in their manager line-up. In some cases, investors concentrated their bets only in one or two active managers.

So what’s wrong with having just one active manager in your equity portfolio?

Picking the right manager

First of all, the majority of actively managed funds have been unable to outperform after fees.

According to various studies, if you only pick one equity manager randomly, then the chances of them adding value is pretty low.

One study in particular, from the S&P Dow Jones Indices, shows that based on a rolling 10-year average less than 20 per cent of funds were able to outperform their benchmarks on net of fees basis.

In a separate study of the eVestment database, we found the proportion of outperforming managers to be less than 25 per cent.

To increase the odds of success, we believe asset owners should undertake detailed due diligence and qualitative research. However, even with our extensive resources and leading manager research process, we estimate a single top rated manager will have a 65 per cent chance of outperforming their respective benchmarks.

Outside interference

No matter how good an active manager is, they will go through performance cycles and inevitably underperform for a period of time.

This could be due to a result of a wrong stock picking decision or due to their particular style (growth/value, size or quality) going through a period of underperformance.

While this may not be an issue for investors who are truly long-term oriented, many investors oftentimes do not have the ability to tolerate shorter-term underperformance due to stakeholder pressure.

As a result, they spend a lot of time and energy questioning performance, making poor hiring and firing decisions based on short-term performance. These decisions often detract value over time.

One may argue investors can opt for a ‘core’ type mandate that is more diversified, in order to avoid prolonged periods of underperformance.

But this means paying active management fees – with limited outperformance at best. It is our view that investors should expect such mandates to underperform after fees over the long term.

So what approach should investors take?

Use a single-manager passive portfolio

A single-manager passive portfolio strategy reduces costs and frees up governance budget for other investments related matters, which are more strategic and effective.

One example might be to allocate this time and energy towards building a portfolio with greater diversity through exposure to new asset classes and strategies, which are less sensitive to equity markets and rising interest rates.

A passive strategy will also be expected to outperform most single-manager portfolios over the long term. As noted earlier, less than 20 per cent of active managers actually outperform their benchmark after fees.

However, using a passive manager means walking away from the potential for alpha to increase portfolio returns.This would be an issue where there is a desire or need for higher returns, and a shared investment belief in active management.

Build a better, multi-manager active structure

For those who choose to stick with their belief in active management, we recommend building a multi-manager active portfolio.

Selecting complementary managers mitigates any potential style biases or market cycle impacts (while a single style might underperform, the chances of different styles underperforming at the same time are smaller).

Relative to both a passive and single manager portfolio approach, we believe this structure improves portfolio efficiency and has a good chance of delivering valuable alpha to investors, especially in the current low return environment.

A well-constructed multi-manager, high active share portfolio can add over 2 per cent per annum of additional return with limited amount of increased risk.

That said, constructing and managing a multi-manager portfolio is complex. It requires significant time and effort to research and select the best managers.

Efficient portfolio construction and monitoring is equally important.

Should an investor not have strong competency in these areas, external expertise will be required to do the job properly.