While there is a tendency to treat manager of manager and fund of fund products as one and the same, the latter has to focus on a UK retail offering and thereby look at a narrow subset of the total fund universe
Within the investment management industry, multi-manager is the new must-have product.
Every few weeks, a new product launch is announced, or so it seems, and with this has come a sharp expansion in the number of column inches devoted to the subject within the specialist press.
Despite this, the quality of analysis of multi-manager offerings remains thin. In particular, there is a tendency to treat manager of managers and fund of funds products as one and the same. This can lead to misunderstanding because, although they share many similar features, there are sufficient differences between the two to provide diverse investor experiences.
Essentially, a multi-manager of any description has three main tasks: selecting managers, monitoring their performance and changing them when necessary.
When selecting managers, the fund of funds is constrained to selecting from investment houses that offer retail funds in the UK. This is a big list ' too big for managers without decent systems and resources. However, it remains a small subset of the total available global universe of fund management talent.
A number of first-choice specialist managers based in the US and Europe chose not to incur the costs of marketing their services away from home. There are also excellent managers in smaller regional markets providing a high level of specialist local expertise that are not at a stage of development at which they can market overseas. And, of course, when they reach that stage, there is no compelling reason their first choice market should be the UK.
The choices available to fund of funds managers are also constrained by more subtle forces. To boost their funds under management, some managers are not beyond adjusting behaviour specifically to achieve good scores from the measuring systems commonly used in manager searches. If stock bets are in favour, portfolios can become more concentrated, if the focus is on star managers, personalities are promoted. If growth has done well, growth strategies proliferate.
As a result, fund of funds manager selections often end up looking similar, focusing on a small group of managers. This sort of concentration can bring problems. Sharp and sizeable inflows into a fund can quickly dilute a manager's pool of good ideas. The same money out can cause problems in raising liquidity if markets are thin.
The manager of managers simply does not have these limitations. They have access to the entire universe of managers, giving superior opportunities to reach the holy grail of strong performance within a controlled risk budget.
After selection, the focus turns to monitoring. Are managers living up to expectations in terms of approach, performance and risk control?
And how do these variables combine across the managers that make up the portfolio? Here the issue is all about access to information. The cleaner and more up to date portfolio data is, the more information it carries and the clearer the picture the multi-managers have on which to base their decisions. Where decisions are made and markets change every day, not having access to full information means less control, more risk.
The best the manager of a fund of funds can usually hope for is a periodic snapshot of their portfolio, compiled from data requested from fund managers or purchased from a third-party source such as Lipper. In contrast, a manager of managers with direct contract relationships can see every trade made by their managers, every day.
There is also a question of relationship. Are you a customer or a partner? When a fund of funds manager buys into a retail fund, they buy into a published prospectus with pre-set objectives, alongside other unitholders. They have no influence over the style of management or the mandate. A decision to change weightings or sectors, or even raise liquidity, can be reacted to and may even be pre-advised if the relationship is strong enough but cannot be controlled.
In contrast, a manager of managers can agree strategy and portfolio constraints and set performance objectives. Importantly, they can also set a risk budget for each manager, enabling them to exercise a strong degree of control over the overall risk exposure of the portfolio.
Only by setting and policing risk budgets for all managers can a multi-manager truly understand the risk of the overall product.
One way in which fund of funds managers try to improve risk control is by pigeonholing managers into so called style boxes. The idea is straightforward enough. If managers can be assembled in such a way that the approaches they profess reflect that of the market as a whole ' large-cap with small, growth with value ' conceptually the fund structure will be market neutral while the portfolio retains a net exposure to the added value they can provide.
It's a nice idea in principle but the devil is in the execution. The main problem again lies with the data.
What most analytical systems do to identify style biases is try to explain fund performance by correlation with style factors. But there are huge statistical problems here. First, indices can perform in a similar way for extended periods of time. Attribution then becomes difficult and the risk of identifying risk exposures where none actually exist high.
The analysis needs an extended series of observations to be significant but then can be thrown off track by style changes during the period, or can miss recent moves due to the preponderant effect of historic data. For those who prefer the simpler approach of relying on portfolio characteristics, such as yield or P/E ratio relative to the market, care has to be taken about accounting changes and the valuation conventions in other markets.
In reality, style information is of dubious quality outside of the US, with a rapid further fall off in value as the investor moves into less sophisticated, less developed markets. What is important for the investor is not what the style of a manager is, or even what the performance of the fund is relative to any claimed style indices. What matters is whether the fund was fit for the purpose it was bought for. Did it help the manager meet their financial objectives and did it do so within expected parameters of risk?
Even with excellent managers, there comes a time when it is right to move on. Sometimes this is because performance is not as expected, sometimes there have been changes in personnel or process and sometimes it is simply that someone better has been found.
Another important difference between the two approaches to multi-management strategies is how these important changes are effected.
For a manager of managers the procedure is straightforward. Because the assets remain under their control, all that is required is that instructions are given to the depositary or trustee to accept instructions from another manager.
There is no need for new accounts to be created and no need, in theory, for portfolio rebalancing, although in practice there is always some limited turnover.
Changing managers in the fund of funds environment is also simple. However, it is generally more costly because one fund has to be sold in its entirety and another purchased. On top of transaction charges, there is a drag from the costs of operating in a retail fund environment ' the move to a cancellation price, the risk of having to phase withdrawal.
The final difference is on costs. In an environment in which market returns are 20% or more, costs are not the prime consideration but when returns are barely double figures in a recovery year, they must be. Once again, the manager of manager holds an advantage.
By placing institutional-sized contracts with institutional managers benefits of scale are achieved. For the fund of funds, buying into a retail-priced fund, even hard bargaining is not enough to undo the damage caused by buying units in an expensive and inefficient structure.
What we have is two very different ways of managing money, confused by an imprecise naming convention. A fund of funds approach offers a stockpicking service, not for individual securities but for the funds that buy them. Without irony, they claim for themselves the skills they believe too many managers lack.
The manager of manager style is to exploit natural advantages of choice, information and costs to meet the real objectives of clients, not for a quarter but for the time horizon appropriate to them.
When selecting funds, the manager of a fund of funds is restricted to selecting from investment houses that offer retail funds in the UK.
Manager of managers can agree strategy and portfolio constraints and set performance objectives.
Changing managers in the fund of funds structure can be costly.
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