Style investing -- in particular growth and value investing -- is a growing phenomenon in international investing, following the example set in the U.S. market. Managing investment portfolios to such narrow mandates can introduce both benefits and problems for investors. Individual plans' decisions on whether to consider narrower international mandates should be dictated by the characteristics of the plan and of its managers.
This article describes some of the characteristics to be considered in making a decision on the matter, and discusses other ways to narrow, or focus, active portfolios, which in many cases will be more attractive than creating separate growth or value portfolios.
Perhaps the first consideration is the plan sponsor's view of the appropriate benchmark. Does the sponsor believe that either passive growth or passive value investing systematically outperforms broad benchmarks? Or does he/she believe that a systematic tilt in one direction or the other merely adds noise, and risk, to the portfolio, without increasing expected returns?
If plan sponsors are agnostic about whether growth or value systematically outperforms broader benchmarks, they should seek to create an international portfolio that does not systematically tilt in either direction. This is most easily done by hiring managers who themselves do not introduce a systematic growth/value tilt into the portfolio, although it does not preclude the possibility of hiring skillful managers whose portfolios do introduce a tilt.
If, on the other hand, the plan sponsor believes that one style or the other will systematically outperform the broader benchmark, how should this be reflected in the portfolio?
There basically are two choices: hire managers whose portfolios reflect those systematic tilts; or adjust the benchmark to reflect those systematic tilts, and hire managers that will take only tactical tilts.
The same systematic tilts should be part of the portfolio irrespective of how they are achieved. Moreover, in principle the plan sponsor could choose the same manager for either approach, and receive the identical portfolio. What are the practical differences, then, between the two choices? Essentially, in the first option the manager gets full credit for both tactical and systematic tilts, and presumably is paid accordingly (especially when performance-based fees are involved). In the second, the manager gets paid only for the success of his/her tactical positions, and is not paid for taking systematic tilts.
As a related issue, when evaluating managers it is important to break down historical value added into that which derives from tactical tilts, and that which derives from systematic tilts. The importance here is that most systematic tilts can be imposed on a portfolio much more cheaply by changing portfolio benchmarks than by hiring active managers.
Consider an extreme example, where Manager X historically has managed his/her portfolio with a substantial Europe Australasia Far East growth tilt. In the past several years, this has resulted in the portfolio outperforming the broader benchmark meaningfully. If the manager has not added any additional value on any other basis, the plan sponsor can derive all of the benefits of hiring Manager X more cheaply by simply adjusting the benchmark to reflect an increased weight in EAFE growth, and then using passive EAFE growth and EAFE value portfolios.
The case for splitting
There are two strong reasons for separating value and growth mandates:
* growth investing requires different skills from value investing; and
* few managers can successfully track every stock in the EAFE, and breaking the mandate up will enforce beneficial focus.
Even if plan sponsors want to be systematically neutral in terms of any growth/value bias in their international portfolios, there still might be situations in which it makes sense to award discrete growth or value mandates. Specifically, if the skills required to add value within the universe of international growth stocks are different from the skills required to add value within the universe of international value stocks, then different managers, with different skills, should be chosen.
Note, however, that specialized skills do not necessarily dictate the awarding of narrower mandates. Conceptually, these managers could manage to the broader benchmark, even if their real skills were applicable to only a subset of the securities available to them. In the extreme case, a manager with skills in picking growth stocks would index half of the portfolio to look like EAFE value, and actively manage the other half against EAFE growth.
There are, however, practical problems with this approach. First, managers might not recognize their own strengths and weaknesses. Second, if managers do recognize their limitations in picking value stocks, they might respond not by indexing half of the portfolio to EAFE value, but rather by investing in more familiar and comfortable EAFE growth stocks. And even if managers both recognized their limitations and were willing and able to purge their portfolios of any systematic growth/value tilts, forcing managers to index half of the mandate results in both a limited opportunity set for the manager and a high-fee index portfolio for the plan sponsor.
Another argument that might support breaking up mandates relates more generally to specialization. One may believe that active managers benefit from having greater focus imposed on them, in this case in the form of a restricted mandate. The flaw here is the arbitrary nature of any discrete partitioning of growth/value as the way to provide focus. In fact, it might be more effective to discretely focus mandates by region, sector or market capitalization, rather than by growth/value.
The case for integration
On the other hand, the reasons for integrated mandates include better return opportunities and better risk controls.
A sensible active manager should be opportunistic in identifying opportunities to exploit on behalf of his/her clients. Any time the manager's ability to form the portfolio is restricted, suboptimal outcomes result. Thus, the arbitrary restriction regarding shifting between growth and value removes a potentially important tool, and that can result in degraded portfolio results. While there invariably will be cases in which the plan sponsor will legitimately want to restrict the actions of the manager (i.e. social or regulatory concerns), in many circumstances those restrictions will not involve separating growth and value stocks.
A responsible manager should try to maximize return given a level of risk, however measured and agreed to by the plan sponsor. More disaggregated mandates will typically lead to suboptimal total portfolio risk, more so than will more integrated mandates. Thus, while both the growth portfolio and the value portfolio might be individually optimal, in the larger context of the total international portfolio, the combined individual portfolios might be substantially suboptimal. Risk is best controlled, and measured, at the level of the total portfolio, not by narrow slices of the portfolio.
There will be, of course, circumstances when it is sensible to form more narrowly defined, suboptimal portfolios. These should only occur, however, when there are meaningful benefits available to the plan sponsor that offset the demerit of receiving suboptimal portfolio management.
Conceptually, many of the reasons for creating separate growth or value EAFE mandates make sense. Separation allows the plan sponsor to control and measure how the manager adds value by providing benchmarks that at least partially purge the active portfolio of systematic growth/value bias. It also allows the plan sponsor to customize both the skill set and focus of individual managers.
There remains, however, the broader issue of whether, in the international markets, growth/value tilts are the most worrisome systematic tilts, and whether skills diverge more meaningfully along the growth/value dimension than they do along other dimensions relevant to international investing. For example, are international managers systematically underweighting Japan in their portfolios, or overweighting emerging markets? Are managers' skills more likely to vary across regions or sectors than across the growth/value continuum?
The international markets are much more subject to possible variation in systematic tilts and differential skill sets than is the U.S. market. One could, conceivably, create benchmarks and hire managers based upon growth/ value, region, sector, weighting in Japan, weighting in emerging markets, and market capitalization. How can plan sponsors deal with all of these dimensions of variation?
There are no easy solutions. The answers depend, to a large degree, on the choice of managers. In the best of all possible worlds, the plan sponsor will identify skillful managers who are able to add as much value without introducing any systematic tilts as can those managers who do introduce systematic tilts. This would simplify the plan sponsor's problem, because it would obviate his/her need to worry about what tilts the entire plan is exposed to. Additionally, it would provide the best opportunity set for managers, both in terms of identifying value added opportunities and in terms of controlling the portfolio risk. It is in order to reap these benefits that many plan sponsors are moving from the EAFE to broader mandates, such as the All Country World index.
The problem is still relatively manageable in the case in which the plan sponsor has identified a manager with real tactical skill, but who will invariably introduce a systematic tilt: benchmarks and mandates, should, in general, be adjusted. If, however, the plan sponsor has several managers, each of which introduces a large number of systematic tilts, it might well be just as easy to provide them with the broad benchmark. In this case, the plan sponsor may need to control and measure the total plan exposure to these systematic tilts by varying mandate sizes among the active managers.
The issue of how broadly to structure active mandates is growing within the industry. In general, broader mandates have the potential to be both more opportunistic and better risk controlled, while narrower mandates have the potential to be more easily purged of systematic tilts and to focus the manager where he or she has the most skill. While this tradeoff must be evaluated on a case-by-case basis, plan sponsors ought not to allow the systematic biases of their active managers to dictate the biases of the plan as a whole. Our research indicates there are active managers with the ability to add value in the international markets without introducing systematic tilts, and they should be the primary focus of most plans.