Saturday, January 19, 2008

Mediocrity - A Superior Investment Strategy?

Investment selection and monitoring is an important responsibility for investment fiduciaries. The investment vehicle of choice for most investment fiduciaries will be a diversified investment fund managed by either; a bank, an insurance company or an investment advisor registered under the Investment Advisors Act of 1940. Investment selection is subordinate in terms of impact to the asset allocation decision for fiduciary driven investment plans such as defined benefit plans but of central importance to fiduciaries of participant driven investment plans such as 401(k) plans.

The investment selection decision tree first branches at the choice between using actively managed funds or passively managed funds. Utilizing a complete array of market based index fund alternatives requires low fiduciary maintenance and provides minimal fiduciary exposure and a highly reliable opportunity for "average" investment outcomes. In practice, institutionally managed portfolios have long recognized the benefits of supplying at least a portion of their portfolio's "beta" or market exposure via these low cost funds. Most fiduciaries understand the basic value proposition for index funds.

In electing to utilize actively managed funds, fiduciaries are implicitly acknowledging a belief and a desire to accept additional risks in return for the potential to outperform a market index on a fee adjusted and risk adjusted basis. The historical returns based decision making criteria broadly used by fiduciaries to profile, differentiate and select actively managed funds is woefully inadequate. It does little to help them understand what risks may be present in the Fund or help them set reasonable performance expectations as they monitor the fund prospectively.

While there are many complicated statistical tools and fundamental characteristics that fiduciaries can use to guide their active fund selection process, one simple attribute to examine is portfolio concentration. Portfolio concentration refers to the number of individual holdings (stocks or bonds) in a fund. The general rule is that the more concentrated the fund (fewer holdings) the more volatile its returns will be, both on an absolute basis (measured as standard deviation) and relative to a benchmark (measured by tracking error or volatility in returns relative to the benchmark). Whitney Tilson, a concentrated value manager describes the arguments behind both highly concentrated and more diversified investment approaches in an FT article.

Simply put, the impact of having an investment decision turn out to be right or wrong in a concentrated portfolio is much higher than in a more diversified portfolio. The degree of appropriate fund concentation depends principally on the fiduciaries confidence in the manager as well as the context in which the fund is offered. Investment fiduciaries whose prime objective is to limit the potential for large losses, would need to have a much higher confidence level (or have a lower overall allocation) in choosing a manager of a concentrated fund over a manager of a more diversified fund given the magnified impact of any bad investment outcome.

In terms of context, a concentrated fund might be suitable (or, in fact, preferable) as part of a carefuly managed portfolio where unique manager specific risks due to concentration are diversified with other non-correlated concentrated funds (ie a concentrated portfolio
fund of funds). From a fiduciary perspective, concentrated funds may be least suitable as part of a participant selected offering such as a 401(k) plan. The performance volatility of many concentrated funds make them difficult to satisfactorily maintain under most general investment policy performance criteria. In addition, higher performance volatility invites irrational investor behavior (sell low buy high) which can be detrimental to long term wealth accumulation.

There is no free lunch in the sense that tracking error & volatility must precede excess returns. Investment fiduciaries however face assymetric risk & rewards. There is significant fiduciary exposure for exposing a portfolio or its investors to downside risk and "unsuitable" diversification. There is little reward for providing opportunities for upside return.

We agreed with Whitney that "the level of diversification exhibited by many mutal funds - holding 200-300 stocks" - can be a "form of closet indexation that invites mediocrity". Yet , diversification can be a post hoc fallacy with regard to mediocrity. Will Danoff is an example, amongst others, of managers who can rise above mediocrity with a very diversified portfolio.
In fact, mediocrity of this calibre, is often superior from a fiduciary standpoint. It reduces the chance of a major loss and with lower volatility than a concentrated portfolio reduces the opportunity for behavioral mistakes that can ruin a long term investment strategy.

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