The Right Number of Managers
Ask A CIO #16
I don’t know if you’ve heard the news, but apparently the Fed lowered rates by 50bps. Surely someone out there has some thoughts around the implications for investors. And surely nobody is overreacting in any way.
In all seriousness, it remains to be seen where the long-term steady state benchmark rate settles. But like many others, I’m eager to see some flow through in terms of capital markets activity. There’s both a logjam of older investments that private funds haven’t been able to exit and ample dry powder on the sidelines across private equity, venture capital, real estate, and other asset managers. Never a dull moment in the markets.
Before we get to our question this week, I want to thank Aoifinn Devitt at the Fiftyfaces Podcast for having me on as a guest. Aoifinn launched the Fiftyfaces Podcast in 2020 to shine a light on the diverse backgrounds and personal stories of investment professionals. Since launching the podcast, Fiftyfaces has hosted guests from just about every type of institutional investor, every asset class, and every major asset management firm. My conversation with Aoifinn about founding Ivy Invest is here, and she’s hosted so many other interviews that are also worth a listen1.
On to the question of the week!
How many relationships should a portfolio have? Concentrate or diversify?
Depending on the portfolio in question – a stock portfolio, a venture portfolio, a portfolio of funds, etc. – there could be a wide range of responses! But since you specifically refer to relationships in a portfolio, I’ll take this as a question about constructing a portfolio of funds.2
As with many investment-related questions, there isn’t a precise answer. In this case, though, I actually have a fairly strong opinion. Well, it’s more that I have a strong opinion about the framework for how to answer this question.3
Before I dive into that framework, let’s establish that having a strategic asset allocation is the first step. You should know what portfolio you’re building toward, before deciding how many puzzle pieces are necessary to build that portfolio. So, assuming you have your asset allocation in place, and the question is solely about the optimal number of managers to meet that asset allocation, I think there are really only two variables to consider: 1) the size of the investment team overseeing the portfolio, and 2) the risk profile of existing and prospective managers.
I’ll start with the second point, which is intuitive to understand and should be fairly non-controversial. For any given manager, you should have a sense for both the risk profile of the manager as well as the risk contribution of that manager to your overall portfolio.
For instance, is the manager’s underlying portfolio highly diversified or tightly concentrated? Does the manager have a volatile or stable return profile? How correlated is the manager to your existing investments? The answers to these and other risk-related questions should reveal something about the appropriate position size for the investment in your portfolio. And position sizing is naturally linked to the number of positions in the portfolio.
A larger, more concentrated position in a manager that has a diversified underlying portfolio is reasonable. A larger, more concentrated position in a manager with a highly concentrated portfolio is likely to inject more risk and volatility into your portfolio. That’s not necessarily a bad thing if it’s intentional, but you probably don’t want too much of that in your portfolio.
If we were to simplify the world of investments into diversified and concentrated strategies (or relatedly, generalist and specialist strategies), a rule of thumb might be – it’s ok to concentrate in diversified strategies. It’s ok to diversify across concentrated strategies. But you probably want to avoid diversifying across diversified strategies and concentrating in concentrated strategies.4 The optimal number of managers in your portfolio will end up as some function of the right position size for each manager.5
Going back now to my first point, team size is also a variable in the equation. Unlike say, a stock investment, which comes with plenty of publicly available data to parse through, investing in managers is necessarily a high touch endeavor. Sourcing, diligencing, and monitoring managers is a manual effort. There are no shortcuts around the investment of time required to build trusted relationships with managers – it’s why they’re called relationships, per your question.
Let’s assume each senior member of the investment team can reliably cover a certain number of managers (I have a number in my head, which may or may not match the number in yours). The question of how many relationships a portfolio should have is inextricably tied to how many relationships the investment team can maintain.
And, this next point might be controversial, but I think most institutional investment portfolios are better served with leaner teams running tighter portfolios.6 It’s a natural inclination for team members to want ownership over some number of relationships. It’s understandable when team members want to add relationships to the portfolio – adding new investments is fun!
But terminating investments is a lot less fun. And the reality that it’s harder to terminate investments really reinforces why portfolio managers should be guarded about expanding the portfolio in the first place. That’s before we even get to the occasional logistical nightmare of exiting investments that have long lock-ups or side pockets. Speaking from experience, that can lead to some challenging situations from an asset allocation and portfolio construction standpoint.7
Summing up, I’m sure you’re delighted that my answer to your question is – it depends! Fortunately, you really only need to consider a couple of variables.
Thanks for joining me this week, and as always, reach out with any questions: askacio@ivyinvest.co!
Until next week,
Wendy
The data and information provided on the Fiftyfaces Podcast are provided for general information purposes only. Buena Capital (dba Ivy Invest) is not affiliated with Fiftyfaces Podcast.
That and, let’s be honest, it’s the one I know best. I’ll note here, in case anyone is curious, that there has been a fair amount of research around the optimal number of stocks in a stock portfolio to balance diversification with active stock selection. A 1987 study published in the Journal of Financial and Quantitative Analysis suggested a portfolio of ~30 stocks, and most subsequent research has supported that range.
This is one of those questions where there is pretty wide range of opinions across institutional investors.
A portfolio that has a large number of small positions in highly diversified managers usually doesn’t make sense. It’s hard for any single underlying investment to move the needle, and there are likely to be a lot of redundant, if not identical, positions.
I am admittedly oversimplifying here. There is some nuance around certain types of investments that are best done in a diversified manner, e.g., emerging venture capital managers.
There is a university endowment that for years had a huge investment team, executing on a number of complex strategies in house. The resulting performance of the overall portfolio was disappointing. Too many people, doing too many things, many of which didn’t need to be – and should not have been – done internally.
Liquidating side pockets, which often stay in the portfolio as hedge fund line items, don’t capture the type of beta or exposure expected from the original investment. At the same time, investors have limited flexibility to manage overall exposures because they’re stuck with these interminable side pocket investments. Yes, I’m still scarred by my past experience with side pockets.