As we’ve explained many times, very few managers succeed in beating the market in the long term, net of fees. But what about those who select the funds for their clients to invest in, namely financial advisers and consultants? Many advisers and consultants claim the ability to add consistent alpha consistent. So is it actually true?
PRESTON McSWAIN and JOACHIM KLEMENT discussed this question candidly on a recent call. Here are extracts from their conversation.
Preston: Can we actively add consistent alpha? This is a question that is on the mind of many inside our industry. As advisers or investment consultants, we all want to be active and add value in terms of performance net of all fees.
In my experience, the problem often comes down to this: How do we do it, especially at scale? When a manager or advisor is small they can be nimble and have an edge, but as they grow…?
Klement: Agreed. Studies show this. Size or capacity can be a real issue with managers, especially in some of the areas that offer the largest opportunity for alpha, such as small or micro-cap stocks.
Preston: A problem can also be the size of the advisory firm or consultancy.
Not only do you have to find the managers at the correct time in a market cycle, when their style of investing is in favour, which is no small task.
You have to also be able to fund them without impacting the manager’s size in a way that reduces their edge. Less is more and scale is your enemy.
As an example, say you are allocating or managing only $1 billion. I know this sounds crazy, but it can be small potatoes, especially as it relates to investment consultants that work with pension funds, endowments, family offices, or high-net-worth individuals.
Klement: Yes, a billion can be very small.
Preston: Yep. Crazy indeed but that can be the reality. Say, for example, that a client hires an investment consultant to invest $1 billion across various asset classes with managers that will add alpha.
The consultant wants to add value net of their fees, but they also understand this. First, smaller is better. Secondly, managers need to be contrarian and can’t follow the herd. And thirdly, allocations of less than 5% don’t move the needle.
Klement: Agreed, again. And let’s pull on that last one just a little.
Preston: Good.
I threw out 5% but in reality, to make meaningful impacts on a portfolio, a 5% allocation may be too small.
Klement: Yes, even if you knock the lights out, a 5% allocation doesn’t move the needle. Let’s assume we find a manager that we think can consistently outperform a benchmark by 5%. This is a big hurdle to start, but let’s put that aside for now. We like the manager but we want to show prudence, so we only allocate 5% to the manager.
Preston: Well, a 5% outperformance hurdle is very big for sure. I’m not sure that I’ve ever seen someone who can consistently find managers who can consistently add 5% over an appropriate best fit index. Even if it could be done, though, it is not enough.
Klement: Exactly. You find the holy grail, but you only have a 5% allocation.
The math is that a 5% allocation to this exceptional manager only adds 0.25% of alpha to the total portfolio. It’s not much more than noise.
Preston: And there it is. Scale is your enemy – you know this. To make an impact, you need to realistically make 10% allocations, which on a billion dollars is a $100 million manager allocation.
Say you find a new micro-cap manager that you and your team are excited about. You want to give them money, but you know that $100 million of new money, especially over a relatively short time period, is highly likely to negatively impact the ability of the manager to outperform in the future.
Klement: Indeed. And you might be able to allocate $100 million for one of your clients, but you don’t just have one billion dollar client. If you invest in the manager for just one of your clients, which one?
Preston: You give the idea to just one client, you’ve played favourites. You have an ethics issue, at least. On the other hand, you give the idea to all your clients and you might blow the manager up and eliminate their ability to produce alpha in the future.
I’ve also discussed this in the past with friends who make decisions on adding new managers to separate account wrap platforms at large investment houses. They want might want to add a new manager, but are often concerned about overwhelming them.
Klement: Yes.
Preston: What would you say is the capacity or assets under management limit for an active micro-cap manager?
Klement: This is hard to get just right but, if I were really looking for consistent alpha, I would start to question a manager’s ability to add alpha if their fund or limited partnership gets bigger than $500 hundred million.
Preston: Back to our $1 billion client example… To move the needle, you would like to make a 10% allocation, which is a $100 million cheque. You know that this might seem large to your client, however, and might impact the manager. So, you dial it back to 5%, which is $50 million.
Klement: And it starts. Now do the manager side.
Preston: OK. Like you, I’ve been on the asset manager side before.
The consultant calls and says that they don’t only have one new $50 million account for you, but multiple ones. At first you are ecstatic. You are a small micro-cap manager and this will make your business AUM growth numbers for multiple years.
Then you think, How are we going to do this? The amount of money will not only impact the portfolio, and potentially trading and operations, it might mess up your composite numbers, because you might have to hold cash for longer than you would like.
So, you call the consultant back, thanking them for the opportunity – big time – but then ask nicely if they could roll the money in over multiple quarters.
Klement: Yes.You get a big cash spike and you know that your nice alpha numbers in your performance composite presentation are likely to go away.
Preston: Right. We all have this problem. We know how to be active. As we talked about last time, though, there’s always a “but” somewhere.
Klement: Yes, as you said before, the “but” is size is your enemy.
As you get larger you become more like the herd. And, paraphrasing a line from one of Howard Marks’ books: “You can’t do the same thing as everybody else does and expect a different outcome.”
If you are in the active world, you have to stay away from the herd and you don’t want to be a sheep. If you do this, though, it is not scalable.
Preston: The problem is twofold. Consultants can’t allocate small dollars.
And managers don’t want to stay small.
Klement: Exactly. Both are businesses.
Preston: Yes, other real life issues. Both investment funds and consultants need to run efficient businesses. Scaling up is good for business but can be bad for returns.
Klement: Scale or capacity can also be issues across a total client portfolio.
Everyone wants top performance, but the desire to be diversified and to control risk is also high. Because of this, money is spread around to multiple managers across multiple asset classes.
Preston: This brings in other issues that increase expenses and reduce efficiency. The total cost of tracking all the managers, public and private, can get high in terms of both time and treasure.
Klement: This is a big problem that even the large sovereign wealth funds are having. They want to do more in privates and venture, etc..
But they have capacity constraints as it relates to proper staffing and resources to stay on top of it all.
Even just being able to understand what allocations really are and what their performance has really been is a big and growing issue.
Preston: I often call it the three Ts: time, treasure… and the biggest one of all, tension. Not long ago I was talking on a panel with head of private investing for one of the largest family offices in the US. The person has a growing internal staff, which costs over five million per year, which does not include potential incentive bonuses that can be based on performance, similar to carry.
In addition, they also employ outside researchers and consultants.
Just the private investment part of the family office is a business unto itself, which the person said took them years to build and takes a good amount of time to manage.
Next, I heard this quote from the Chief Investment Officer of a large public fund on one of their calls. The CIO basically said this: “Private equity and venture are the only asset classes where we are committing capital before we understand what our exposures are really going to be. It then takes us 10 years to get fully invested and then another ten beyond that before we understand what our returns have really been.”
Klement: Yeah, it’s crazy. And gets even worse if you go into direct deals. They often take even longer for you to figure out what your returns are.
As your person said, it might take a year or more to build a proper team, which costs a good amount, and that is before you even invest much.
Then you have to consider all the costs of the private investment managers or deals, and your costs to track all investments and produce performance and exposure reports.
The inefficiencies of allocating to multiple managers and private investments can become quite high. It’s a heck of a lot. Oh, and if you concentrate too much, it is like gambling. It can be fun and stimulating, but the odds are not in your favour. Like the Vegas house, it’s the Street that wins.
Preston: Back to where we were before, maybe you can add value, but small is your friend. Small doesn’t win you a lot, though.
Klement: You’re right. You’re absolutely right.
Preston: You know, we all want to believe we can make a difference and add consistent alpha.
A few years ago, I wrote a piece, Say it Ain’t so, Joe. Like you, for the majority of my career I believed that managers and manager selection processes added significant amounts of value or alpha. After stepping back and looking at the independent evidence, though, I often feel like that little kid in the Field of Dreams movie looking up at his idol, Joe Jackson, and saying, “Say It Ain’t So, Joe.” Say it ain’t so, Joachim. Say it ain’t so.
Klement: I wish I could. As we have discussed, the problem is both a scale and market cycle one. Fund managers tend to be good in either bull markets or bear markets, but not in both across a cycle.
Let’s say you find a manager that has a track record that looks good over 10 years, as markets generally rise. When you look closer, though, you tend to find that many managers are just high beta plays. So, you have to ask yourself, Am I willing to pay a manager 1% or more in annual fees to get one point or so, when I could just add leverage to an index fund and come out the same or better?
Preston: You see this for sure, especially when looking at rolling period relative performance trends and performance consistency. You’ll find what seems to be a top performing manager, who is certainly hailed in “top” fund lists or in their own presentation materials, which are all from Lake Wobegon.
You then open up the hood and find, let’s say, that the fund has been concentrated in technology.
On the one hand, you can applaud them for the bet. On the other, when you compare them to a technology index, they don’t look so great. Finally, you then have to ask if their ability to win with concentrated sector or name bets is sustainable.
Klement: That’s the problem. Like what we experienced in the 90s. The stars were all the ones that went into dotcom stocks. It all can look good, until it doesn’t.
Preston: Yes, indeed.
Klement: So, where do we go from here, when adding consistent alpha is so very difficult?
Preston: That is the big industry question. Maybe we just need to be more open — more transparent about our ability to find the best of the best at the correct time and, if we do, about our ability to right size them.
It’s not that investors shouldn’t try and that we shouldn’t keep a lookout for opportunities. How about just being more candid that the odds aren’t that great, especially at scale, and that costs are high?
Klement: I totally agree.
PRESTON McSWAIN is the Managing Partner of Fiduciary Wealth Management, based in Boston, Massachusetts.
JOACHIM KLEMENT is a London-based investment strategist.
This transcript was first published on the FWP blog and is re-published here with permission.
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