Multimanager providers and financial intermediaries face the tricky task of explaining to customers multiplying middlemen (and women) fund managers can produce superior overall returns.
Most retail investors find the concept hard to understand, given the presence of more people between the assets being bought and the end customer in most other industries usually means slightly higher prices and without any immediate sign of improvement in quality.
There is also the difficult question which asks how many funds is too many, and at what point a policy of diversification of assets simply a dilution of money between an excess of smaller and smaller pots?
Robert Burdett, joint head of multimanager services at Credit Suisse Asset Management, says diversification is about reducing risk, although it must be done in a way to ensure returns are not reduced.
"It boils down to the lost art of portfolio construction, he says.
This means the fund manager must be able to hold positions in a number of riskier funds instead of a single less exciting one.
CSAM relies on style research and a software package to crunch the data on funds in the portfolio from different managers.
Part of its process includes looking for tracking errors relative to the benchmark indices used by each of the individual funds, and applying forward modelling on whether positions should be increased or reduced.
It is about creating a "sensible" portfolio at any point in time, Burdett says.
Similarly, investing in new funds early in their lifetimes can also be important, rather than waiting for fund performance figures.
"Diversification allows you to back people off their trade records," Burdett adds.
Anthony John, director at IMS, says his company is "in the camp of diversified portfolios" applied at multiple levels of diversification.
These means looking at funds styles, how often they rotate holdings, what is seen as core holdings as well as market capitalisation values in order to assess a prospective invsestment.
Moreover, key factors in managing multimanager investments can also depend on liquidity and size of funds they invest in, John says.
All these factors combined mean diversified portfolios can provide higher than average returns. However, investors need to beware of claims which suggest lower risk is linked to lower tracking error, an argument IMS’ John "does not buy".
John cites the period of the TMT bubble, when "some of the best" managers traded well away from benchmarks, but were actually creating less risky portfolios than the indices of the time.
IMS, he says, looks for a blend of higher and lower tracking errors across big and small capitalisation values, in order to capture higher alpha. Enabling this selection process is the ability to compare "like funds with like funds", which can be trickier than it sounds.
The difficulty, argues John, is some managers hide their true intentions while within sectors. From John's perspective, a fund-of-funds manager needs to look at a broad enough universe of funds because in a sense there is no such thing as "best of breed", he says.
Most managers have two bad years in every seven, which means it is important to have knowledge of which factors can knock them down, he says.
So-called "hard factors" may be the state of the economy, while "soft factors" include, for example, changes to the terms of their mandates.
Quantitative analysis is important, but "today more than ever the emphasis needs to be put on qualitative analysis," John says.
"You need to eyeball the manager."
Gordon Davidson, joint managing director of Jupiter, says the end of the two-decade bull run reminded people of the importance of asset allocation. Hence, the issue of value for money and what diversification may bring to the investor have regained importance.
People may believe they are paying more, but if they get better performance, the "proof" is in the numbers, Davidson says. There is still likely to be focus on buying at the best price, but if there is a demonstrable outperformance, it is worth paying more, he adds.
"If you pay less you can end up paying twice," is the mantra. Paying more for flexibility to switch between asset classes easily can also pay more in some cases, Davidson concludes.
This article was produced by IFAonline, as part of the joint IFAonline and Insight Investment analysis of the multimanager investment sector.IFAonline
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