Trustees mostly understand that it is a risk to engage a single manager to manage their fund’s assets within a single investment mandate. But do they understand what risk or risks they face and which one will be reduced through the appointment of more than one manager and what is the correct number of managers to use?
What risks should we be concerned about?
First consider what risks one is facing. These are:
- Systemic risk
- Prudential risk
- Advice risk
- Market risk
- Volatility risk
- Currency risk
- Scam risk
- Lost opportunity risk
- Liquidity risk
- Investment risk
Does a combination of manager address all these risks?
Combining more than one manager will reduce the prudential risk that something can go horribly wrong with one organisation. It will reduce the volatility of performance because the volatility of each manager will differ from that of other managers. It will also reduce the scam risk, the liquidity risk and the investment risk of capital loss and underperformance. It will not impact on the advice risk, market risk or lost opportunity risk. Advice risk and lost opportunity risk will need to be managed at fund level, while market risk needs to be addressed by spreading investments across different markets e.g. local and offshore market.
What is an optimal number of managers one should combine?
Evidently a combination of more than one manager within a single investment mandate of a fund does reduce most risks funds face when placing their investments. However will it suffice to engage only two managers or should one engage more than two manager? This is a tricky question and really depends on the skills of the trustees and their objectives.
How bold are the trustees in taking active decisions?
If the trustees are totally averse to actively engage in investment decisions and are comfortable with average returns, the answer is, ‘the more the merrier’ as each additional manager further dilutes the risks, approaching the answer very simplistically. There are of course much more sophisticated methods such as the efficient frontier model that will indicate that little further value is added after a certain number of managers have been combined and from where on one would actually produce negative outcomes.
The Namibian environment sets narrow confines
Being realistic about this within the confines of the Namibian environment, most funds are too small to employ one segregated investment mandates, let alone engaging more than one manager on a segregated mandate but have to invest via unit trusts. Since unit trusts are regulated by dedicated legislation and are subject to statutory supervision, the prudential and scam risks are already reduced to a significant extent and probably require very little additional attention of the trustees.
Due care and skill requires active engagement
Due care and skill would probably require of a board of trustees to engage actively in investment decisions and to achieve results better than the average for their members. This means that they will have to think carefully about how to combine managers and how many managers to combine. Given the wisdom of engaging at least two managers, a successful combination of two managers has the best chance of out-performing but of course also has the best chance of under-performing. The greater the trustees’ confidence in the ability of the selected manager to outperform, the fewer managers need to be combined and visa-versa.
What are your performance objectives for combining managers?
The question then is what objectives do trustees have in combining different managers? The objective can be one of the following:
- Superior performance
Choosing managers who are likely to outperform the average manager in the long-term. Such a combination may lead to all managers under-, and out-performing the average at the same time. The trustees need to be clear on this and be comfortable with the consequence thereof, particularly in times when all managers under-perform the average. This is obviously the ideal combination given the conviction that all managers should out-perform in the long-term. Unfortunately in Namibia, only very few managers have a long-term history of out-performing the average. The other managers have all had extended periods of either out-, or under-performance, or have no long-term performance history. Performance history therefore does not render any significant level of conviction for any of the managers outperforming the average in the long-term.
- Above average performance
Choosing ‘core’ manager/s who is/are likely to out-perform the average in the long-term and an/other non-core manager/s who is/are likely to produce returns mirroring those of the average as closely as possible. The expectation of the non-core manager/s is to cushion any significant under-performance of the ‘core’ manager/s. Performance history should show which manager’s/s’ performance has most closely mirrored the average over the long-term.
- Hedged performance
Choosing managers with an opposing investment philosophy and style (i.e. value vs growth). If all managers on each side of the spectrum were to perform equally well and equally poorly during periods advantaging and disadvantaging their investment philosophy and style, the combined performance of these managers should mirror that of the average. Again the realities of the Namibian environment are that there are very few if any managers that can clearly be placed on either side of the spectrum making it questionable whether the hedged performance strategy can be employed successfully.
Important notice and disclaimer
This article summarises the understanding, observation and notes of the author and lays no claim on accuracy, correctness or completeness. Retirement Fund Solutions Namibia (Pty) Ltd does not accept any liability for the content of this contribution and no decision should be taken on the basis of the information contained herein before having confirmed the detail with the relevant party. Any views expressed herein are those of the author and not necessarily those of Retirement Fund Solutions.