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Greetings!
This is part three of a six part series on Opportunity Classes. Opportunity Classes allow you to broaden your approach to investing by focusing your strategy on risk and opportunity, rather than exclusively on security type (e.g., stocks, bonds, etc.). This week we will be looking at manager structure. As always, I invite you to comment on this innovative approach. This e-Newsletter includes a Letter to the Editor regarding a potentially interesting fixed income opportunity, please see below.
Six Opportunity Classes to Consider for Your Investment Strategy:- Asset Allocation (read more),
- Super Regional Allocations (read more),
- Manager Structure (below),
- Manager Selection,
- Using Leverage, and
- Currency and Foreign Exchange
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Opportunity Classes: Manager Structure
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Summary
| | Selecting the right manager structure for your portfolio can be both fascinating and challenging. Furthermore, the more exotic your investments are, the more difficult manager structure tends to get. However, with proper guidance, these challenges are surmountable. |
 Five Ways to Think About Manager Structure:
| Here are five (5) ways to help you craft a manager structure that is appropriate to your specific circumstances:
- Active vs. Passive Investment Structures (or some blend of the two)
- Fixed Income Manager Structures
- Equity Manager Structures
- Marketable Alternative Asset Manager (or Hedge Fund) Structures
- Non-Marketable Alternative Asset Manager Structures
I. Active vs. Passive Investment Management Structures
The difference between an active manager structure and a passive manager structure is the following: a passive investment structure seeks to replicate the performance of capital markets benchmarks (e.g., US Treasury bills, S&P 500, Dow Jones 30 Industrials, MSCI emerging markets, etc.). By definition, a passive approach does not seek to outperform its benchmark in a rising market or to protect you in a falling market.
A structure that embraces active managers seeks to outperform capital markets benchmarks through research, security selection, concentration, market timing and other techniques. One thing to bear in mind is that active managers who are highly diversified may charge significantly higher management fees over time than passive investments; and yet it may deliver returns that are extremely close to its capital markets benchmarks. A word of caution, be careful not to be a so-called 'closet indexer,' meaning someone who pays full active management fees and suffers unnecessary taxes, while getting a passive return with little or no manager value added.
Deciding to use a passive vs. an active investment structure does not imply that you will have a simplistic or unsophisticated portfolio. Given the enormous array of passive investment vehicles (e.g., mutual funds, exchange traded funds or ETF's, and certain separately managed accounts), you can construct an elaborate, sophisticated passive investment strategy. Please note however, that passive structures that attempt to replicate alternative assets returns are a dubious proposition. If you wish to invest in alternative assets, then you would be well-advised to use an active management structure for at least that portion of your portfolio of investments.
Taxable investors (i.e., private clients) typically have a higher hurdle than endowments in deciding to use an active management structure. This is because active managers tend to generate more taxable income from their higher trading than do passive structures.
II. Fixed Income Structures
Your fixed income portfolio may be designed with several elements based on the duration/maturity of the bonds, credit quality, geography and taxability, or a combination of these. For example, you may want to design a manager structure with short-term bonds (under 3 year's duration), intermediate-term bonds (between 3 and 7 years duration) and long-term bonds (those over 7 year's duration). Advisers may have differing views about exactly how to carve up these three categories, but this serves as an example.
You may also want to construct your fixed income manager portfolio with separate allocations to the highest quality bonds issued or guaranteed by sovereigns and corporations (e.g., AAA and AA bonds), a broad collection of investment grade bonds, and finally sub-investment grade bonds (also known as junk bonds, or sometimes as a credit portfolio).
Investors may design a manager structure within different geographies (e.g., their home province/state, country or region). As I have mentioned before, your currency strategy should be integrated with, and mindful of, the geographies encompassed by your manager structure. Further, taxable investors may allocate a portion of their fixed income portfolio to tax-aware fixed income (including municipal bonds) with a mandate to maximize risk adjusted after-tax total returns.
Three Caveats for Fixed Income Investors:
- You may want to consider a global manager for super high quality bonds, investment grade bonds and/or your credit portfolio. If you take this approach it is essential to work with your adviser in determining whether your global bonds will be: currency unhedged relative to your home currency, partially currency hedged to your home currency, or fully hedged.
- If you adopt a global approach, do not be surprised to find emerging markets bonds in some of your bond portfolios, including your highest quality portfolio. Emerging markets bonds may offer both a better return and higher quality than some of their developed country counterparts.
- Select the benchmark for each fixed income account/fund/ETF with great care. The selection of the benchmark will determine the lion's share of your investment return in fixed income.
III. Equity Structures
There are at least three types of equity structures, all of which are applicable to either a passive or an active management approach. These three structures vary in terms of complexity.
One of the simplest approaches is the complementary structure. The complementary structure combines a small number of managers whose investment styles complement each other. For example, you may combine a value oriented manager with a growth oriented manager. The complementary structure can be made more robust by combining large capitalization equities managers with one or two small capitalization (value and growth) equity managers. Again, the structure can be further enhanced by adding complementary managers who invest in equities outside of your home country or region.
Another interesting approach is known as a core satellite structure. The core is typically a passive (or semi-passive tax-managed) allocation to a major national, regional or global equity market benchmark. The satellites are typically active managers who run concentrated portfolios with a distinct approach and a low sensitivity to deviating from their equity markets benchmarks. The mission of the satellite managers is to provide significant value add vis-�-vis the core of the equity portfolio. The core satellite structure is designed to reduce overall management fees, while empowering the satellite vehicles to deviate from benchmarks as they strive to add value. Naturally, the investor needs to be aware that deviations from a benchmark can be either positive or negative.
A third type of manager structure is the donut structure, also referred to as a string of pearls structure. You might think of this structure as a core satellite structure with the core removed and more satellites added. Given the collection of managers and low degree of benchmark sensitivity, you run a reasonably high likelihood of deviating significantly from a benchmark. These deviations may be either favorable or unfavorable in any given year.
Of course there are other ways to structure your equity portfolio, but these three approaches are worth your consideration.
IV. Marketable Alternative Assets or Hedge Fund Structures
I am not a believer in the claim that one can achieve attractive hedge fund returns using a passive management structure. I understand the math and the techniques, and I am just not convinced. That leaves you with two choices: 1) build a portfolio of direct hedge fund investments, or 2) employ one or more hedge fund-of-funds.
The problem with the first choice is this: building a portfolio of direct hedge fund investments with adequate manager diversification requires substantial resources. Hedge fund minimums are $1 million or more per fund for the highest quality funds. If you agree that you should have at least 15 funds to contain manager specific risk, then you can do the math. Furthermore, you will need hard-to-access research in order to make safe and effective manager choices.
Alternatively, you may engage one or two hedge fund-of-funds. The rub here is that hedge funds charge significant management fees, and introducing a fund-of-funds results in another layer of fees. Additionally, while you may not need as much research to identify the best fund-of-funds, you will certainly need a very experienced, unbiased adviser with a keen eye for total asset management fees and a full appreciation of the quality of the fund-of-funds' underlying managers.
Whichever structure you employ, you may want to engage managers (focused on both your home region and global managers) who can address both long/short equity-oriented opportunities and so-called absolute return strategies (including merger arbitrage and distressed securities).
V. Non-Marketable Alternative Asset Managers
To some, this arena may be even more complex than the world of hedge funds. First, you need to evaluate whether you are a candidate for investing in assets with no investor elective liquidity. That is, the money you commit is "called," or invested only when the manager is ready to invest it. Further, your money is returned to you only when the manager achieves liquidity in the investments made with your capital. Basically, you have no capacity to request the return of your capital when you want it.
Again, I am not convinced that you can achieve attractive passive returns in venture capital, private equity, natural resources and private real estate. The scale of resources required to build a diversified portfolio of direct fund investments (vs. fund-of-funds) is substantial, the manager selection research is highly proprietary, and access to the funds you really want to get into is quite constrained.
It is fair to say that as the asset classes in which you invest become more arcane or obscure, the burdens of doing your job successfully escalate; and the more helpful it will be to have an experienced, unbiased adviser to help you. |
| Conclusion | In developing a manager structure, the most fundamental decision you should start with is the proportion of assets you want to invest passively vs. actively. You will also need to develop a comprehensive manager structure that will support your investment strategy. Your structure can be as simple or as complex as suits your preferences. Having focused on your manager structure, you will then need to populate your structure with suitable managers, funds and/or ETFs. The more complex your manager structure, the more extensive your use of active management, and the more committed you are to alternative assets, the more help and advice you should seek from professionals to stay out of trouble and to achieve you goals.
Naturally, your manager structure should take into consideration your choices about other Opportunity Classes. In other words, be mindful about how your manager structure interfaces with your decisions about Asset Allocation and Super Regional Allocations, previously address and manager selection, leverage and currency to be addressed here in the weeks ahead. Please see my two prior e-Newsletters.
As mentioned before, if this sounds subtle, you may want to work with an adviser or Private Investment Counselor in crafting an investment strategy and implementation plan that will meet your specific and customized needs. You need not leap from where your portfolio is today to where you may want to go over time. If you set a course and identify the goals that you want to achieve, then you can more readily track your progress.
I hope that my approach to helping you develop the right manager structure for your portfolio is helpful. I am eager to receive your feedback and Letters to the Editor. Please let me know what you agree/disagree with, as well as your views about manager structure. Click here to shoot me a note, and with your permission I will publish your Letter to the Editor. |
Letter to the Editor
| "In thinking about their fixed income portfolios, investors may want to consider the "contingent capital" bonds that banks are likely to issue under Basel III to help them meet Basel III's new requirements. These are bonds that convert to equity (or are written down if the issuer is a mutual or cooperative bank) if the bank's capital position deteriorates. Much thus depends on where the triggers are set and how they are pulled; however, the couple of deals that have been done (Credit Suisse, Rabobank) have looked attractive in terms of yield and appear to face a low risk of actual conversion.
"Until the market settles down, these instruments are likely to have to be richly priced to facilitate their sell. Naturally, an investor and their advisors should exercise careful diligence vis-�-vis conversion terms, triggers, etc. That said, there may be some real opportunities at manageable risk levels in the early days of the market. The regulators may be pushing banks to issue these bonds, probably starting in the second half of the year."
David J. Schraa, Esq., Director of Regulatory Affairs, Institute of International Finance, and Member Reynolds Group Private Investment Counselors' Board of Advisors. |
About Us
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Reynolds Group, Private Investment Counselors™, LLC helps high net worth individuals, families, private foundations and charitable trusts enhance risk adjusted investment returns, drive operational efficiencies and optimize advisor effectiveness.
email
Jack at RGPIC dot com
617.945.5157
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- Boston area private banker
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