InvestorDaily spoke to Colonial First State head of FirstChoice investments Scott Tully, Russell Investments client portfolio manager Annette Vlismas, ipac Securities chief investment officer Jeff Rogers, MLC Investment Management head of investment communications Michelle Heinrich and Treasury Investment Services committee chair (fund manager for Premium Investors) David Cooper about how their diversification strategies have held up during the downturn and whether they have changed their investment approaches as a result of the crisis.
ID: In general, what sort of an impact has the GFC had on multi-manager models?
VLISMAS: A multi-manager is built to have a mixture of different talents and works on the principle of diversification, and if you look at the events of 2008, during that period it was very clear that there was a big risk event that occurred across asset sectors. It didn't matter whether you were in bonds or equities - there were falls in asset prices. So the idea behind diversification really was that you were prepared for the recovery in asset prices when it was coming, and we've seen very strong results coming out of multi-manager simply because of that feature - that you do have a range of different decision makers. So, in general, multi-manager has delivered that diversification for people to have the benefit in this recovery phase.
ROGERS: It is clear that the financial crisis was a stressful period for all investors, not just multi-manager. But if I think about the sort of things the multi-manager offer delivers one of them is almost more diversification by asset class and by strategy. I think we observed that the correlation effect, the diversification of all these different sources, clearly didn't work as well in the crisis and therefore tested the competence of people in a multi-manager approach. So I think it certainly caused us to reframe the way in which we explain how that diversification works.
TULLY: I always get a bit worried when people start separating multi-manager from ordinary diversified funds, so there's definitely issues that our multi-manager funds had to deal with through the last year. Everyone had some issues. But I think the benefit for the financial adviser is that there was someone there looking after those funds for them and I think that held up pretty well, so the adviser who had adopted a multi-manager approach could be confident that there was someone sitting behind it and still undertaking that risk management and monitoring process, which for a single management diversified fund they don't quite have the same surety about. But I agree . that the way we explain diversification needs to be better articulated.
HEINRICH: Or the other interpretation of course is that diversification equals risk minimisation and the reality is that diversification equals risk management, and the one thing that multi-manager obviously attempts to do is to apply that risk management concept more deeply and more broadly.
VLISMAS: What we learned was there is a new risk element, stock volatility, that is the identification of situations where you had corporate reputation or corporate sustainability becoming an issue. So now the research process has this stock volatility item in it, to make sure we can measure it across portfolios, rather than just within a single manager part of it. So we are looking to broaden that out and that will be one of the changes in our research process going forward.
ID: Has anyone else made changes to their research process?
COOPER: Not really. From our point of view the global financial crisis is an opportunity to expose the weaknesses in multi-manager. Everything went up and then everything collapsed, and so this whole business of diversification was tested. It gives you the opportunity to question your multi-manager approach. Are we over-diversified? Are we too academic about what we are doing?
HEINRICH: The criticism of over-diversification in the world of multi-manager is an interesting one. If you take it to a really high level, the reality is that diversification is required because of the world of uncertainty that we live in.
ROGERS: I think the argument comes down to how many genuinely good managers you can find. If you can get managers who are going to outperform, you will outperform. At least if you are a little bit over-diversified, you may not deliver as much alpha as you claim, but you won't blow up. Whereas in a single manager situation, a concentrated situation, you might do very well but there has got to be some chance of blowing up.
ID: Is there any sort of guideline or limit to how many managers you would ideally use?
ROGERS: I don't think so. I think it is a personal belief. It's a belief thing that can only be evidenced after the event and, as it has turned out in Aussie equities, to the extent that the median manager in Aussie equities ends up having done really well, which is a bit of a false guide because the median is a bit of a strange thing. It does indicate that if you looked over-diversified you'd probably have ended up delivering still, whereas in other markets that hasn't been the case.
ID: You reduced the number of managers within the Australian Equities Fund from seven last year to about four. Was that your way of addressing over-diversification?
ROGERS: I don't think the managers we eliminated are necessarily going to underperform - the thing we were focused on there was efficiency. In Aussie equities you have got the concentration issue and in some sense there are some more micro issues that you might like to deal with. Clearly you want to outperform but you don't want to have sort of excess turnover. So it's not saying that seven managers is wrong, because if you have got seven good managers it will work. But what we're saying is by limiting the number of managers and some mandate design we feel we can capture most of that, but with more efficiency.
TULLY: It's about balancing the economies of scale with full investigation.
ROGERS: If you are a big fund in Australian equities I do think there is a reason for having a few more managers, because if as a big fund there is a manager you lose interest in or something happens and you need to move that capital quickly, you had better have a relationship with someone who can take that large amount of money. So it is linked to your beliefs about who is good and also your business circumstances.
HEINRICH: And I suppose it's about the role the manager's playing for you. If you look at the Aussie equities as the case in point, the reality is that our market is small. If you want someone with a capability in small cap, you are going to cap them out pretty quickly, so you need to think about how much you are actually allocating to get the alpha that you expect. So those things become important as well.
COOPER: Do you think there is any scope in the future for the multi-manager to have a view on markets or a forward view on valuation?
ROGERS: It's less about taking a view than potentially defining what I call a different product with a different outcome and communicating to your potential clients that you are doing something different.
HEINRICH: In the context of a traditional multi-manager diversified portfolio, it is an additional small lever you can introduce to the strategy. It is something that we are just now starting to think about. We call it a strategic overlay to avoid the tactical, short-term thinking that traditionally surrounds active asset management. But it is strategic overlaying in the sense that it is thinking about making minor adjustments within our traditional diversified portfolios. But it is also applicable at the manager allocation level.
ID: What about benchmarks? Are the right ones being used?
HEINRICH: We become obsessed with the S&P/ASX 300 being the right benchmark to outperform, but at the end of the day what are we really trying to do for our end clients? Are we are trying to build wealth or preserve what they've got and that's a very different benchmark? Who's to say the ASX 300 is the right benchmark for that?
VLISMAS: I think the brief, though, is that people get some visibility or transparency in what you are proposing to deliver and in Australian shares it is the ASX 300 for all of its concentration and everything. But multi-manager then looks at that benchmark, looks at the active manager universe and thinks about how to get broad market exposure within the portfolio and for any inefficiencies that are going to be a source for alpha in that portfolio.
COOPER: I think your issue about benchmarking is huge. We've been barking on about it for quite a while because if you go to the ASX and look up how they put the benchmark together, nowhere is it stated in any literature that 'this is how to invest your retirement savings'.
ID: So is there a more appropriate benchmark?
HEINRICH: Well, if you think about it from a retail investor's perspective, particularly from the superannuants who are looking to build retirement wealth, it's really got to come back to building wealth over and above inflation, and over the appropriate time frames. So there have been various attempts by quite a number of us to use that as the right benchmark and I still think intuitively it is the right benchmark.
TULLY: I think you've got to remember that most of the money we get . is not into an Australian equity fund alone, it's into a diversified fund. So really the benchmark is not quite so relevant.
HEINRICH: I often call it the 'keeping up with the Jones's' index. We are obsessed with the median manager at the diversified fund level and that becomes a benchmark that you sort of have to beat. So when you are constructing product to take to market to meet a need, you have multiple masters. One, you have got to deliver to the end client's objective and that, as you say, will change through time. Two, you've got to be competitive or you won't garner the funds. How you benchmark that will either be against the ASX 300 at the sector level or it will be the median manager in the diversified funds sector, which as you know is almost sometimes like comparing apples and zucchinis, based on the underlying investment strategy of some of those diversified funds.
ID: Can financial advisers help make multi-manager funds more effective?
HEINRICH: If you pulled a client file out of any financial adviser's drawer, chances are what that adviser has built for the client is a multi-manager fund. The reality is that everybody recognises the benefits of a multi-manager strategy. The question is how efficiently are you putting it together for the client? So, I think the true role of a good financial planner is to listen to what the client is telling them and match that to the right solution, first and foremost with their interests in mind.
TULLY: But it amazes me that financial planners, those who think they can provide tax advice and social security advice . also think they can choose managers. It staggers me because we spend time talking to portfolio managers and we make assessments of their quality. Whether it's right or wrong, we at least are close to that fund manager.
HEINRICH: And even if you are an adviser who does do stock research or fund manager research to build your own portfolio, the most rational way to start that process is to start with considering the risks first and not the potential, and it's often the other way around.
ID: In the global financial crisis most asset classes lost value. Does diversification still work or should one develop a more macro-economic view?
VLISMAS: I think the general view is you're better to spread your assets together to get a broad range of asset exposures. Yes, you can tailor it to be able to be specific, to get the narrow exposures that you want and at the same time you can use other sources of risks. Diversification does work - it is still the only free lunch around.
HEINRICH: But the segmentation approach that a lot of planners do implement in Australia, of course, is the core satellite. Multi-manager, fully implemented portfolio solutions are an obvious core strategy. Your risk-seeking client, even high net worth, probably thinks intuitively in that space where they segment different parts of their wealth and maybe take some more risks with one bucket and less with another. The way a typical financial planner of course does that is with a similar approach, even with their half-a-million-dollar client. They might say, 'well, you know we need to make sure this money is there for you'.
COOPER: People value negative return higher than they do an outperformance of a benchmark and a positive.
VLISMAS: And they tend to react more to a negative return.
ID: One of the things to come out of the GFC was obviously liquidity being an issue. Has it been an issue for your sector and do you have to revisit some of the managers that you selected to see what their liquidity management is like?
TULLY: We value liquidity, so we haven't had a problem with having access to our underlying assets. The problem has been that those assets, because they are liquid, have suffered greater downturn and therefore it has impacted our returns relative to those funds. We are comfortable with that because we know that we can get out of those ones and as markets have rebounded we have had less issues with that. So we haven't had any problems with liquidity, except in a sense that it has been a slightly wild ride in terms of returns. But we have been very comfortable that if we need to access our assets, then we can.
The liquidity story is yet to actually play out. We've been through the performance side of it but those funds that have a high weighting to illiquid assets, they're the ones who have structurally got problems. We've come through . but the funds who have a large allocation of 30, 40, 50 per cent to illiquid assets, they are the ones who in the next year or two will have material problems in my view.
ROGERS: I do think it sets up the possibility of having a set of products that is not for everyone, that might only have a quarterly or even annual liquidity event . I would have to say that if I was a trustee of a super fund that had 25 per cent illiquid assets or more last year and I was unsure about the valuation, and people were putting new money in, I would ask 'am I being fair to those people putting new money in?' Because maybe they are putting money in at a price that isn't the one that ought to be there.
Some of our mandates have guidelines for managers about how much they can be weighted in sectors and duration. I think we are trying to be more explicit about how much liquidity risk they can take relative to benchmarks. And clearly it's a hard thing to define - just because something went illiquid last year and something else didn't it doesn't mean that next time it'll be the same sort of security, liquid or illiquid. But I think we are trying to capture in mandates some sense of how much liquidity risk we want them to take because we may want to call upon that liquidity.
HEINRICH: And tied into all of that is that other hoary industry chestnut around, matching the time horizon with investment strategy to the true time horizon of the investor, because that's the challenge in all of this, isn't it?
ROGERS: If you think of what happened to some - the mortgage funds and some of the other funds - it is almost as if the rational behaviour was 'I think the fund is fine, but I better get out before other people who don't understand get out'. And so that's a rational response and that is, I would argue in some cases, poor product design.
HEINRICH: You're almost better off being hard upfront to set the expectation of the client, so if the adviser recommends a satellite strategy that is illiquid, they know they can't access this except once a quarter or once a year, or whatever.
COOPER: It might also have something to do with the fact that we're all running a unitised vehicle that's open every day.
ID: I just wanted to throw out the question - how important is style in selecting underlying managers in multi-manager approaches?
COOPER: Well . to be brutally honest it virtually doesn't come into it at all. We just say, 'look, we're just looking for people with tons of experience'. You know you need 10 years in this game to have any idea of what you're doing. I mean you're looking for things like how the team blends together, how they get their ideas and how those ideas are executed.
All Australian equity managers are getting out of bed every morning trying to pick stocks that go up. That's their style. So does that flow into blending? I think you've go to do it because it's absolutely ludicrous to buy three guys that all try to buy Apple - what's the point of that?
HEINRICH: Especially if they get it wrong.
VLISMAS: Sometimes you have to go down to the individual holdings. We go through every Australian equity manager's holdings quarterly and we've got a long database for it and you go along and interview them and they say 'we make decisions based on these three steps'. And then you analyse their trading and individual stocks and you can see they're not really sticking to that description they gave you. You just make sure that people consistently follow this process and then you can be assured that you have got the mix right in a multi-manager portfolio, because sometimes it's a matter of 'well, they're a value manager but for some reason they didn't fire in this last rebound'.
COOPER: We found good investors just have very good emotional intelligence, so they're a bit like somebody walking into Harvey Norman and saying, 'gee the flat screens are half the price, I'm buying two'. Investors generally don't think like that - if the share price halves they will run for the hills. However, an emotionally intelligent investor will say: 'I thought this was a good company and it's now half the price. I'm gonna start chipping in now.' So their emotional intelligence is very strong when the herd is actually going the other way.
VLISMAS: Say the insights are built into a portfolio where you've got two extremely different managers. That's exactly what's behind this 20-stock select holdings portfolio that Russell is running, because the underlying managers are of all different calibres and beliefs about value and value in the security, but not in a style sense. So they see an opportunity arising out of these different perspectives. So it's not the fact that it's 20 stocks, it's really this idea that people with disparate views come together and make a better decision because what multi-manager is building in is not only a combination of skills but looking for a higher success ratio. And getting that sort of overlap from these extreme views is actually the chemistry inside it. If you get away from diversification and all the marketing spin we put around it, it's people with different views agreeing and anything they don't agree on has got a zero holding or is possibly not held in the portfolio.
