Master manager offers flexibility in pursuit of alpha

By Richard Ennis and Neeraj Baxi

A "master manager" combines elements of an indexer, overlay manager, transition manager, master custodian and consultant to achieve the flexibility needed to seek alpha where one can find it, without being constrained by asset-class considerations..

Under such an approach, investors would continue to set their strategic asset allocation, such as 50% U.S. equity, 15% international equity and 35% fixed income. To add value, an investor would seek to hire managers with the highest prospective information ratios irrespective of the asset class. An investor could hire a manager in an asset class that is not included in the strategic asset allocation (e.g. high yield or emerging markets equity), or hire managers in international equity with an allocation greater than the strategic allocation (more than 15%), or hire long-short managers. But this would cause the actual allocation to be different from the strategic asset allocation. That's where the master manager comes in.

A master manager would perform the following functions:

• Implement the marketable securities component of the policy portfolio. This would be done using a combination of index funds, exchange-traded funds and derivatives as cheaply as possible.

• Make cash or securities available to fund the active managers. The master manager can use futures to gain exposure to certain market sectors. As futures require only a 5% to 10% margin, the remaining free cash can be used to fund a new manager. Or they may conduct a transition from a passive portfolio to an active portfolio.

• Monitor risk and compliance of the active portfolios.

• Neutralize any unintended factor exposures. If all the active managers are strictly market neutral, there will be nothing for the master manager to neutralize. For managers that bring factor exposures, such as stock market beta, a value bias, a high yield beta or unwanted leverage, the master manager would adapt its portfolio to neutralize the unwanted exposures.

• Rebalance the portfolio and balance the active risk budget.

In the quest to separate alpha and beta, investors face two challenges. One is cost. Alpha-only strategies are priced richer than traditional long-only strategies, and a master manager will need to be compensated more than a traditional passive manager.

The second challenge is making an accurate assessment of the factor exposures of the active managers, especially those that do not offer complete transparency of their holdings.

Consider an investor with a total portfolio of $100 million and a strategic allocation of 50% to the Wilshire 5000 stock index (approximately 40% S&P 500 and 10% Wilshire 4500), 15% to the Morgan Stanley Capital International Europe Australasia Far East index and 35% to the Lehman Aggregate bond index. The investor decides to hire four active managers as follows:

1. An emerging market equity manager for $5 million

2. An EAFE equity manager for $20 million

3. A long-short market neutral manager for $20 million

4. A fixed income manager for $10 million

While some of the above managers seem inconsistent with the policy, they can be incorporated into the portfolio if the factor or market betas can be adjusted to achieve the required betas. A master manager can help achieve this goal. A master manager can go long index funds, long or short ETFs and long or short derivatives to achieve the strategic allocation and make cash available to fund the strategies.

Once all of the above strategies are implemented, you get your policy exposure, plus the active risk of the managers. A small amount of cash ($10 million) is still available, which could be used to manage rebalancings and balance the active risk budget on an ongoing basis.

Chart 1, read along with Table 1, seeks to illustrate how an investment program would be implemented with a master manager. Figures in green represent long exposures, while figures in red represent short exposures. Netting them, you would get a market exposure of $100 million, in line with the strategic allocation.