How can Investors Avoid Outsourcing Risk Management?

So what’s the answer in the Aussie market with Aussie clients, Fox?

Great question. I have a simple answer but unfortunately not everyone’s going to like it.

The truth is that most Australian fund managers are unlikely to offer a highly concentrated Australian equity portfolio that’s invested in a handful of stocks. The are very well aware of Professor Greenwald’s warning.

It’s a kind of suicide pact on your future because sooner or later you, if you’ve got a three, four or five stock portfolio in one industry it’s going to blow up.

This is especially true in Australia. The concentration of the Australian market at both the industry and the stock-level greatly increase the risk of short-to-medium term under-performance (for a detailed explanation of the reason why see l my earlier post HERE).

This greatly raises the stakes for Australian equity fund managers that dare to be different.

For example, I know a fund manager that manages a Sharia-compliant Australian equities fund. The fund does not invest in banks due to the Koran’s restriction on lending in exchange for interest.

The fund continually bounces from being the best-performing fund manager over the last month to the worst performing fund manager over the last month.

The swings in performance have very little to do with the stocks the fund manager is invested in and everything to do with the performance of the big four banks, which the strategy obviously does not invest in, that make up approximately one quarter of the Australian equity market.

Fortunately for this fund manager, the clients invested in this Sharia-compliant fund are not primarily motivated by benchmark-relative performance, otherwise they would probably be out of business.

There are other reasons why a fund managers are unlikely to offer highly-concentrated portfolios. One reason is that it limits the amount of money that they can manage, which obviously limits the amount that they can earn in management fees (for more information, see my earlier post HERE)

Still, I have a lot of sympathy for fund managers because it’s not all their fault. The truth is that their clients are also to blame.

Many institutions want to hire managers that can beat the market, however they find it difficult to be patient and to accept the short-to medium-term under-performance that inevitably comes from active management (for example, see my earlier post HERE and HERE)

So back to your question, what can Australian investors do? There are several possibilities:

  • Buy the index. This is not as dumb an idea as it sounds (please see my earlier post HERE).
  • Index the top 10 or 20 stocks and use active managers to invest in mid cap and small cap stocks.
  • Use factor based strategies, Momentum and low volatility have historically worked well in Australia.
  • Renegotiate with fund managers and only pay for the active investment component. I think this is fair but it will be hard to get fund managers to accept this.
  • Use no more than 2-3 fund managers in an Australian equity portfolio. This helps to reduce the problem of redundancy (or offsetting positions between managers).
  • Centralize your trading and only execute the net trades (see Professor Greenwald’s comments about AT&T in my last post HERE.

Each of these possibilities has potential benefits and drawbacks.

There is another possible solution. Some may think its risky but I think there’s an excellent chance that it will work. It looks something like this:

  1. Fire all of your current active fund managers. This will save a lot of time, money and effort.
  2. Appoint an index manager to implement a custom index supplied by you quarterly. This will be very cheap for an institutional investor.
  3. Find a group of fund managers that you think have skill.
  4. Figure out what their top mid and small cap stock picks are. This is easier to do that it sounds but I’m not going to tell you how to do it because I don’t give trade secrets out for free.
  5. Select the 10-12 highest conviction positions held by your group of preferred fund managers.
  6. Decide how much you want to invest in the 10-12 highest conviction names and how much you want to invest in the index. This will depend on your willingness to go through short-to medium-term under-performance.
  7. Create a custom index by blending the 10-12 stock “best ideas” portfolio and the index in whatever percentages you need to get your desired outcome.
  8. Get your index manager to implement the custom index.
  9. Repeat/rebalance quarterly.

Why do I think this will work? There are several good reasons:

  • You are ahead by 0.3% – 0.5% per year before you’ve even started thanks to the investment management fees you’re saving.
  • You’re probably saving a lot of money on brokerage and tax too.
  • You are relying on the “wisdom of crowds” by using the combined insights of several fund managers that you believe have skill.
  • You are removing the principal and agent conflicts that result in most fund managers failure to fully back their best ideas.
  • You are extracting the fund manager’s best ideas. There is ample academic research showing that best ideas beat the market.
  • You aren’t paying a high management fee for “risk management”.
  • You can switch managers at ZERO cost. Simply add or subtract a manager from your research and adjust your portfolio at the next quarterly rebalance.
  • The problem of redundancy or off-setting positions disappears.
  • You have full control of how different or similar to the market you want the portfolio to be.
  • The overall portfolio is really no different to the overall portfolio that you get when you invest in 5-6 fund managers. Only difference is you’ve cut out the middle men. If you want to know why I say this, use the contact form to get in touch and I’ll send you a detailed explanation.

I would be very interested to hear what my readers think of this idea. I look forward to reading your comments.

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