Generalists vs. Specialists
Ask a CIO #9
We could talk about the Fed holding rates steady and what might happen in September.
Or we could talk about Simone Biles and the powerhouse women’s gymnastics team! Stephen Nedoroscik, aka Pommel Horse Guy, helping the men’s team medal for the first time in 16 years! Katie Ledecky in a league of her own!
Every four years, we get to watch and celebrate the world’s best athletes come together to astound and delight us with their superhuman talents. We become experts overnight in obscure sports. We have opinions on rules that 24 hours ago we didn’t know existed. The Olympics are such a joyful, unifying event!
I’ve got the Olympics on my mind, so I couldn’t help picking a question this week that felt related (but really isn’t).
Should investors invest in generalists that can opportunistically allocate capital or a collection of specialists in niche markets?
This is a great portfolio construction question. It’s the subject of perpetual debate in investment offices. And like so much else in investing, there’s no black or white to this answer, just shades of gray.
Broad strokes, from what I’ve seen in my prior institutions and in peer portfolios, institutional investors typically take a balanced approach, investing in both generalists and specialists. To get to that blend, there’s usually a thoughtful progression:
An investor makes an initial foray into a market or asset class through a generalist manager.
As the investor becomes more fluent and familiar with the various nuances of that market or asset class, the investor develops a viewpoint on certain niche areas.
The investor decides to dedicate capital to those niche areas through specialist managers.
Stepping back for a second, if we’re being completely blunt, a portfolio doesn’t need specialist managers. A reasonably compelling, complete portfolio can be built with generalist managers.
But I do think you would be giving up potential excess returns, particularly in certain niche markets. So then the question becomes, in which markets do specialists have an investment advantage? Followed by the harder question: which of those niche markets warrant dedicated allocations?
In my experience, the list of markets in which specialist managers have an investment advantage is long, but the list of niche markets that warrant dedicated allocations is much, MUCH shorter.
The problem inherent to investing in niche specialist managers is that you’re investing in one niche area. A niche area could be a specific geography, industry, type of security, part of a capital structure, some combination of the above, etc. And many of these niche areas can be cyclical, meaning the most compelling relative opportunity set today could turn into the least compelling relative opportunity two years from now.
Perhaps you’re thinking – ok, so just invest in the specialist when the opportunity set is good, and don’t invest when the opportunity set is not good. In a perfect scenario, yes, of course! But as we’ve discussed previously, market timing is hard. And it is even harder in niche markets than in broader equity markets1.
On the other hand, as I noted above, staying consistently invested in these markets can be costly (even if it is just opportunity cost). As the old adage goes – when all you have is a hammer, everything looks like a nail. I have very rarely encountered a manager that willingly says, “this isn’t a good time for my strategy, so here’s your money back, you’re better off investing it elsewhere.”2 More often, the specialist manager will do their best to find opportunities in that niche market, which can result in reaching for returns or taking on new risks that lead to strategy drift.
I know I’ve been speaking in generalities here, so let me use some specific examples to help make my point. In the hedge fund world, multi-strategy managers are the generalists. They provide exposure to a range of strategies, which can include long/short equity, merger arbitrage, convertible arbitrage, distressed credit, commodities, etc. A generalist multi-strategy manager allocates capital to each of these niche areas in proportion to how compelling the opportunity set is at any point in time. You, as an investor, benefit from their insights and their ability to be nimble across these niche strategies.
Distressed credit is one niche strategy in which specialist investors arguably have an advantage. I might offend some readers here (sorry!), but I also think distressed credit is a cyclical opportunity set. In the aftermath of the global financial crisis, distressed credit strategies generated high risk-adjusted and absolute returns over a multi-year period3. And then the opportunity set went mostly quiet for over a decade, leading some specialist investors to reach for returns4. There have been small pockets of distress (e.g., Covid-related in 2020), but until recently, it’s been a generally benign credit environment5.
Whereas a multi-strategy manager’s allocation to distressed credit can fluctuate with the investment environment, a specialist continuously pursues that one strategy regardless of environment6.
So when does it make sense to allocate to specialist managers? I’ll put forth two situations, which sometimes overlap, where I think it makes the most sense. The first is in niche markets where the difference in skillsets between a generalist and a specialist are significant and this difference is reflected through a high dispersion of returns – biotech investing comes to mind here.
The second situation is in markets that are structurally attractive as opposed to cyclically attractive and the base case return for that structural opportunity is either high enough or uncorrelated enough (or better yet, both) to justify a consistent allocation in a portfolio. Lower middle market private equity buyout strategies come to mind here.
I’ve gone on far longer than I intended to when I started this answer, so thanks for bearing with me. I’ll end with one entreaty.
Whatever you decide is a compelling niche market to allocate to is ultimately up to you. But try to avoid the conundrum, which I’ve seen occur, where you allocate to a basket of specialist managers across an asset class, intentionally or unintentionally recreating a diversified generalist-like portfolio. In this instance, you’ve probably neutralized the benefits of your specialist investments while also taking on the burden of capital allocation.
I really enjoy the chance to dive into topics with you all each week. Your questions are thought provoking and challenge me to articulate the often unspoken principles I’ve seen and practiced over the years. Please keep them coming: askacio@ivyinvest.co!
Until next week,
Wendy
Niche markets almost always reflect something not easily traded, so the underlying assets are less liquid, if not illiquid. And the fund structures through which you would invest are also not easily entered into or exited.
It does happen from time to time, and I have a lot of respect for those managers!
To find more opportunities, many U.S. investors reached into Europe, which turned out to be a questionable adventure. Investing in distressed credit in Europe is a different beast, with different rules across different jurisdictions, and a greater emphasis on various stakeholders than is typically shown in the U.S. In fact, European distressed credit is a great example of where you might want a specialist, if in fact you believe there is a persistent opportunity in European distressed credit.
To be fair, I do think we’re about to see distressed credit opportunities open up, both in corporate and commercial real estate. There have been several high profile restructurings so far this year, and there are a lot more highly levered borrowers with upcoming maturities to go (going back to my comments last week on Fed rates not likely coming down quickly or sharply enough to provide relief).
And maybe makes the case for post-reorg equity. Kidding aside, I like a lot of distressed credit managers! It’s actually one of my favorite investment strategies. But the cyclicality is real.