Discovering moments of mispricing is the soul of generating active returns, says Wylie Tollette executive vice-president of client portfolio solutions at Franklin Templeton Investments.
But some investors, eager to discover opportunities to add alpha to their portfolio mix, may accidentally harness so many sources that their efforts to diversify actually hinder the benefits of doing so, he says. To encapsulate this phenomenon, the industry has coined the term diworsification.
When large institutional investors form a team whose job is to seek out and hire managers, that’s what they’re going to do, he says. “You can frankly end up with a lot more managers than is rational. And that is increasingly true in markets where there is not a lot of inefficiency or mispricing to be leveraged to generate alpha.”
Especially where highly liquid markets like equities from the Australia, Canada, Japan, Western Europe and the U.S. are concerned, employing a slew of managers, all trying different strategies to generate alpha will, when taken together, replicate the behaviour of an index fund, says Tollette.
This problem comes with the context that investors, no matter their size, can gain cheap access to the world’s most efficient markets.
Putting a factor lens onto an efficient market will push fees higher, but mildly, he adds. It’s the next step up the fee curve as it’s trying to capture more sophisticated or so-called smart beta.
These rules-driven, quantitative approaches to capturing factors like value, quality or low volatility are coming down in price – ranging from five to 15 basis points or so, Tollette says.
Often, if a manager’s approach is dissected, it will be essentially comprised of market beta and one factor tilt. “If that factor can be quantitatively created and extracted you don’t need to pay 70 basis points for it. You might only want to pay 15 basis points, because consultants are increasingly doing this, they’re separating out beta which you can get for free and that alpha, that looks a lot like smart beta, then can probably be had at a fairly low fee level.”
That’s not to say all managers are created equal, he adds. “Traditional fundamental strategies that have a proven track record of generating alpha using good old fashioned stock picking or bond picking, they’ve traditionally had a higher fee. And they should have a higher fee, they earn every penny of that.”
Some organizations are now recognizing the downsides of expanding the number of managers they work with. For example, the California Public Employees’ Retirement System, of which Tollette was previously chief operating investment officer, made major cuts to its equity emerging manager program, bringing more equity management in-house in 2019. “Unfortunately what you got when you had all of these edgy managers is that they may have been individually edgy, but if you had enough of them, you just get back to the index you were starting with and you end up paying fees for that. So in the long-run it doesn’t necessarily benefit the client.”
Even in less efficient markets, like private equity, there is a danger that investors can overload their system with so many managers that their total performance will end up reverting back to the a median return for the asset class, he says. And in private equity, the higher fees have all the more potential to bite into any generated alpha.
In real estate as well, specifically core real estate with far more institutional eyes examining the same class of building, there is more and more efficiency. “There’s still inefficiency, but there are a lot of institutional investors who’ve made it their business to really understand the price of those office buildings, and they’ve driven a lot of the mispricing out of those markets so it’s not as easy as it used to be.”
Ultimately, avoiding diworsification is about building a strong core of the most efficient assets in the portfolio. Then the search for satellite managers, who demonstrate an ability to consistently outperform in certain areas, can begin, he says. “And if you can’t find those managers that can consistently generate alpha in that market, then don’t select them.”