What alternate solutions to multi-management?

a few of our business partners are asking for the rationale behind the implementation of our asset allocation strategies through active multi-management versus either passive index management or single-stock management, both seemingly cheaper solutions.
The multi-manager approach to investment is a process of selecting external asset managers to manage each sub-asset classes of the investment universe. This approach is actually strongly criticized. What about the true cost of alternate solutions ?

First alternate solution: passive index management

The passive index management is a process of investing in index-linked underlyings (trackers, ETFs ...) designed to replicate, with the lowest possible cost, the performance of a given index. On paper, the effective low cost is clearly a positive advantage relative to active multi-management.

For instance, let’s consider the universe of European Large-Cap Equity Index funds. Boursorama’s database provides a list of about 15 funds. The management fees of these 15 funds are 0.31% on average per annum [1]. In contrast, the management fees of the three funds currently in our European Equity pocket are 0.83% on average [2]. The cost advantage is - all things being equal - 0.5 percent per annum.

The talent and expertise of some duly selected managers are the pledge of a good potential outperformance.

Emmanuel Regnier

Now, let’s do the performances comparison - our three European equity funds and the basket of 15 index funds - since June 2009 (inception date of the most recent fund). Index funds posted 34.1 percent over the period with a volatility of 17.4 percent similar in size to that of the MSCI Europe TR Index which exhibited a compounded return of 40.5 percent. Our three selected funds (which were already in our portfolio in June 2009) posted strong performances ranging from 48.7 percent to 54.7 percent [3]. In others words, 15 to 20 percent above that of index funds with an overall volatility of 17.0 percent for the pocket. More performance for less risk: these two figures summarize the benefits of good multi-management versus index management.

The talent and expertise of some duly selected managers are the pledge of a good potential outperformance (alpha), whereas a tracker, despite a lower cost, will underperform its benchmark with a probability of 1. Moreover, diversification, resulting from a combination of low correlated investment approaches within the portfolio, reduces the overall risk.

Index management might be detrimental to performances over the long run.

Emmanuel Regnier

Not to mention the hidden costs of index management: those related to the tracking of an index whose design lacks efficiency and can be detrimental to performances over the long run. Indeed, the vast majority of index funds tracks market-cap related indices [4]. Let us not forget that in 1989, Japan accounted for nearly half world’s market cap before underperforming the rest of the world by 10 percent per annum on average over the following two decades. Similarly, half of the components of a market-cap index in 2000 were tech stocks, just before their 90 percent losses. A talented and active asset manager could have prevented these disasters. And what about the weight of Enron or Lehman Brothers in a bond tracker just before their bankruptcy, or the weight of Argentina in an emerging market debt index (more than 20% of the JPMorgan EMBI +) before its 2002 default? A good active manager would surely not have these lines in his portfolio while the index fund would have merely replicated losses well above its few basis points of cost-saving benefits.

Second alternate solution: single stocks management

Another alternate solution to multi-management is single-stock management whose stock-picking is directly done by the allocation manager in order to generate outperformance on each asset classes in his investment universe. On paper, this approach has, here again, a cost-saving benefit.

Humility (clear-sightedness?) is the primary reason for choosing the multi-manager approach to investment.

Emmanuel Regnier

Researchers in psychology have shown that 93% of drivers consider themselves to be better drivers than average. This overestimation of own abilities or overconfidence is also found in the area of asset management: Behavioral finance provides a list of damaging effects. For us, an allocation manager who believes to be able to select, with the same rigor and the same success, U.S., European or Asian equities but also emerging market debt, high yield bonds or commodities, clearly shows an overconfidence which can be dangerous. Humility (clear-sightedness?) is the primary reason for choosing the multi-manager approach to investment.

Then, assuming that our allocation manager has in-house expertise or has succeeded in designing a powerful stock-selection methodology, we can definitely believe that third party entities are able to do at least as good as him, or at least differently: Given same levels of performances, it is less risky to invest in several strategies: why shall we lose the benefit of diversification?

Finally, assuming an allocation manager has enough staff resources to follow the microeconomics of all asset classes in his investment universe (which is very expensive); the chances that he succeeds in creating long-lasting value on each of them are extremely low. And even if he achieves his goal on a subset of these asset classes, He would still have to deploy additional resources to prevent his most talented staff from leaving and joining competitors... As each management company has limited resources - time, capital, and staff - it is merely impossible to be the best everywhere! In contrast, be able to carefully select the best specialists is a hard-to-achieve but realistic goal for a management company willing to commit on means

We believe the multi-manager approach to investment is the worst approach except all the others.

Emmanuel Regnier

To rephrase the quote of Churchill, we believe the multi-manager approach to investment is the worst approach except all the others. Its disadvantages (especially induced costs) seem very small compared to its advantages over existing alternate solutions, from both behavioral view (avoid overconfidence) and economic (limited resources) perspectives, both in terms of performances (alpha) and risk management (potential diversification). The multi-manager approach to investment has good days ahead...until the emergence of a credible alternate solution