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A False Sense of Diversification?

November 29, 2016  | by David Scarozza

Asset Allocation | Equities | Investment Strategy

As we have undergone the process of re-underwriting all of Commonfund’s equity managers and funds over the last 6 months, we have tackled anew the age old question of how many funds does one multi-manager equity portfolio require to offer appropriate levels of diversification?

While there is no single universally appropriate answer, our research has indicated that, upon closer inspection, many multi-manager equity portfolios may not be quite as diversified as intended from a potential excess return perspective.

By and large, traditional active equity managers, as defined in our research by more than 2,000 US equity managers who report their results to Bloomberg, do well or poorly together in significant lock-step with how three second-order market risk factors are performing.  In the chart below we examine how active managers’ performance moves in response to three equity factors – size (small cap vs. large cap), volatility (high vs. low), and crowded trades (as represented by the Goldman Sachs VIP index).  Specifically, if small caps perform better than large caps, crowded trades outperform less-favored trades and higher volatility names do relatively well, chances are good that your traditional stock pickers will outperform their respective benchmarks.  In the reverse environment, the likelihood is that active managers will underperform.

 

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Our findings are particularly relevant as some investors struggle with the question of whether to persevere with their actively managed equity portfolios or to throw in the towel and join the throngs of those investing passively.  At Commonfund, we firmly believe that active management will be a necessary ingredient in meeting long-term performance goals as we believe the passive beta available to investors from equity and fixed income allocations simply will not be enough to meet long-term spending and capital growth needs. 

The implications of these findings are nuanced but important.

  • First, and admittedly ancillary to this particular research, this does not indicate to us that one would want to abandon active management. On the contrary, coming out of a difficult environment for active management, reversion to the mean alone might portend better times to come.  We want to make sure that our client portfolios are positioned for any rebound in the active management environment by having verified alpha-generating stock pickers in our portfolios.  Furthermore, we will concentrate in our highest-conviction manager partners. 

  • Second, it is important to recognize that “traditional” active managers, or stock pickers, tend to gravitate towards equities that bubble up to express similar factor bets at the portfolio level. This indicates to us that while investors may gain comfort in feeling sufficiently diversified by having multiple stock pickers in their portfolios, the true diversification of the excess returns they are producing may be overestimated.

  • Finally, we are spending considerable resources to find and bring “non-traditional” active or excess return sources to our equity portfolios in pursuit of demonstrable diversification benefits. In other words, we do not want to have all of our eggs in the traditional active management basket.  We are executing this strategy through the targeted and risk-aware addition of quantifiably uncorrelated risk premia and diversified alpha strategies.  Needless to say, identifying managers that meet this criteria is no easy task, but well worth the effort.

Our investment philosophy is grounded in the three tenets of the endowment model – an equity bias, broad diversification and prudent use of illiquid investments to capture the premium they can offer – we believe they remain the foundation of a successful long-term investment portfolio.  But today we are executing the model using refined tools, like those described here, to isolate portfolio risks and identify uncorrelated sources of return more reliably.

Authors

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David Scarozza is a member of the Commonfund Asset Management Investment team and is primarily responsible for asset allocation, manager sourcing, due diligence, and investment monitoring for investment portfolios. He serves as a member of the Commonfund Asset Management Investment Committee. Prior to this role, David was a Managing Director on the hedge fund team and prior to joining Commonfund, he served as a Vice President and the senior manager analyst on Citigroup′s fund of funds team. David received a B.A. in Economics from Swarthmore College, completed a one-year program of study at the London School of Economics and received a M.B.A. from Columbia University.
David Scarozza
Managing Director

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Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.