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August 03, 2011 01:00 AM

How can we escape the 'bucket' problem?

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    Question

    We are an investment management firm with one product that we try to sell into the U.S. institutional marketplace. The problem we continuously face is that our strategy doesn't fit neatly into the “buckets” that consultants and institutional investors use to categorize money managers when establishing their strategic asset allocation; it becomes a real problem in the manager search process. Are there ways around this problem?

    Answer

    A quick observation is that some old practices in our industry die hard. What made sense when there were fewer investment opportunities and fewer investment strategies really doesn't make much sense now. Institutional portfolios have assets in many regions around the world, asset classes within those regions, styles of management within the asset classes, multiple vehicle types within the styles and multiple fee schedules within those vehicles.

    Forty years ago, most U.S. defined benefit plans had the proverbial 60/40 domestic equity and fixed income asset allocation: i.e. two major buckets. Sometime in the 1970s, real diversification began to happen. First, real estate was added to large corporate DB plans. Then index funds really began to blossom after the bear markets of 1973-‘74. First there were S&P index funds that bought all 500 stocks at their market weight (its own bucket) and then index replication funds, which bought sectors and industry groups trying to replicate the returns of the broad markets but with fewer names, hence less costly to maintain (another bucket).

    So the number of buckets was going up exponentially. Styles of equity management were “bucketized” thanks to consultants, leading to small-cap value, midcap growth, large-cap core and all the combinations and permutations around these simple constructs of market-cap size and stock characteristics.

    Next, large institutional portfolios started investing in non-U.S. stocks. Back then we called it International diversification, which when added to U.S. stocks became “global” and so it went.

    Fortunately, some managers, consultants and asset owners eventually created two wonderful new buckets called “opportunistic” and “special situation,” which has given everyone a little wiggle room, but doesn't really solve your problem.

    I will give you a description of an actual product that is being aggressively marketed to institutional investors and that, I think, sums up the conundrum. A manager is offering a first-time evergreen “fund” that is long only, invests in small ($200 million minimum market cap) and midcap ($1 billion maximum market cap) public companies in emerging and frontier markets using a relational activist (collaborative) strategy for starters. They are trying to unlock value (hence a “value style”), and it is highly concentrated with holdings in the range of eight to 14 companies. The firm is an emerging manager and has a fee schedule that is structured like a hedge fund with a management fee and a performance fee based on producing a return greater than a broad emerging market index with a hurdle rate and a lockup. Now this is a product that doesn't really fit neatly into any one bucket.

    Nonetheless, there are two conditions that are very favorable for this manager. First, its performance from inception to date exceeded the benchmark by 59.21 percentage points, but more importantly, consultants and asset owners are really trying to be more flexible as to “where this product fits” in relatively large, well-diversified institutional funds.

    Yes, this product could fit in the emerging market bucket, the small-to-midcap bucket, value style and concentrated buckets to name a few. But some consultants and asset owners now want the idiosyncratic exposures (expected returns and risks) that this product and others that don't fit a certain bucket offers. It is clearly a complement to what exists in many large institutional portfolios.

    In short, so long as you have the performance, a product with so many attributes it is hard to fit into a single bucket will attract institutional investors, who will find a bucket that fits best or will create a new bucket for it.

    So my advice is to emphasize not just the uniqueness of your product but how its multiple characteristics will complement all their other holdings.

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