Counselling - PORTFOLIO STRUCTURE OPTIONS
There are two types of structures used in portfolio management. They both have advantages and disadvantages. The type of structure recommended will depend to a certain extent on who is making the recommendation and the size of the portfolio.
The multi manager, specialty asset class structure of managing portfolios is common in very large pension and institutional portfolios. It is also the structure most commonly recommended by brokerage firms and financial planning firms. The balanced manager structure is most commonly used by private clients with large portfolios and the non profit sector.
The two structures require different oversight and governance procedures. These differences can result in very different cost structures and time commitments.
MULTI MANAGER, SPECIALTY ASSET CLASS
Clients who use this structure believe that portfolio managers should be specialists rather than generalist and that returns can be enhanced while risk is reduced by identifying and hiring specialists in each asset class.
A fundamental principal of this approach is that clients and their advisors should set a long term policy asset mix and stick with that. The asset mix management is static. When additional cash flows are received or when the markets have impacted the relative valuations, the portfolio is rebalanced back to the policy asset mix.
This type of approach is appropriate for investors with long time horizons who are most concerned with opportunity risk. Since the markets historically have gone up two thirds of the time, the premise is that investors will wait it out until the market comes back.
To reduce risk and provide style diversification typically two or more managers will be hired for each asset class. These style differentiations usually begin with value versus growth and often include large cap versus small cap. The theory is that no one can predict which style will be in favor at any given time so the risk of substantially underperforming the market due to style is reduced. In fact these types of structures do reduce volatility around the median in the performance of the portfolio.
While this type of structure does achieve some real diversification and risk reduction benefits there are also some other potential risks. The first is that the cost of portfolio management is increased so any enhanced returns may be dissipated due to higher costs. Of more concern is that the overall risk of the portfolio is not being managed. Since each manager within the asset class is constructing their portfolio independently some risks may actually be increased. This is an issue when overall portfolio sector risk is considered. Nortel and the technology sector is an excellent equity market example. The Canadian equity managers may choose, independently to overweight Nortel and the technology sector. At the same time the U.S. equity managers may be overweighting Cisco and other tech stocks. The overall portfolio may have a risk profile that was unintended by the investor. The only solution is for the consultant to manage the sector risks and exposures and consultants are not money managers and not active on a daily basis in portfolio construction.
Currently all the multi manager programs available select managers based on geographic asset classes yet most investment managers are moving to global sector research platforms. It is difficult to analyze the technology or banking or forest products sector in one country without also following the industry globally. The trend in corporate structures is toward more global companies and business combinations as evidenced by the recent trend in mergers. This is combined with a trend for the largest global companies to list their stock in more than one market.
While this structure does provide the opportunity to reduce manager specific risk and provide the opportunity for specialist management with greater expertise it also brings the potential for a higher degree of sector and security specific risk to the portfolio.
BALANCED MANAGER MANDATE
Clients who use this approach believe that the investment manager should be managing all the risks of a total portfolio. This includes the asset mix risks, sector and industry risks as well as the security specific risk.
Some common types of risk apply to both the fixed income side of the portfolio as well as the equity side. The most common is interest rate risk. It applies to both the bond investments as well as to many sectors in the equity markets. When approaching this risk from a total portfolio basis, a decision could be taken to increase this risk in equity by taking an overweight position in the banks and financial services but to balance this off by keeping the duration and term of the bond portfolio shorter than the universe. The total interest rate risk is determined then tilted toward either the equity or fixed income portion of the portfolio.
The second significant difference in this approach is that it normally includes active asset mix management. The portfolio manager decides to either underweight or overweight particular asset classes based on their outlook for various markets. This at a basic level will determine the relative weight between bonds and equity but will normally also continue with tilts within each broad asst class such as away from Europe and toward the U.S.
Balance mandates will always include allowable ranges within which a manager is allowed to tilt or shift the portfolio. For investors who place a higher priority on capital risk than opportunity risk this is the appropriate type of mandate.
The disadvantage of this type of mandate is that not all managers are good in every asset class. A manager who has demonstrated excellent returns in Canadian equity for example may be week in the international arena. There are a number of ways of addressing this. Many managers have retained sub-advisors to manage some of these asset classes on their behalf while retaining the asset mix management. Some clients have decided to focus on firms that have expertise in the asset class mos important to meeting their objectives and that can add the most value to the overall portfolio.
The two principal advantages to this type of structure are that the total portfolio is managed encompassing all the risks at various levels of the portfolio and the costs are normally lower. Some clients with multi million dollar portfolios will decide to obtain additional diversification by hiring two managers with complementary balance mandates.