US Equities: 20 heads are better than one
Joseph Mariathasan takes a look at Neuberger Berman’s Flexible All Cap US Equity strategy
The sheer size and diversity of the US equity marketplace means that there are many niches that fund managers can specialise in to produce attractive and potentially outperforming portfolios. Indeed, with many global companies domiciled in the US, alongside smaller domestically focused businesses, the opportunities do not even have to be particularly dependent on the state of the US economy.
In the US, it is usual for institutional investors to have a number of different US equity managers covering the full range of styles and market size segments. For European investors, having more than one US equity manager is less common. But combining the advantages of focused portfolios run by specialists with diversification across the market is possible only through having a number of different managers - and smaller pension schemes in particular would usually find such a strategy an inefficient way of approaching the marketplace. However, Neuberger Berman has recently launched a product that might offer a cost effective way of resolving this dilemma.
Many large US equity managers offer a range of equity strategies run by different teams within the same organisation. These strategies can have contrasting risk profiles and different tracking errors against benchmark indices.
In addition to its benchmark-focused equity strategies, Neuberger Berman has 20 less benchmark-constrained active equity teams, all running long-only portfolios with no leverage and an average of 30-40 stocks in each portfolio.
Although their styles are very different, managing director Alan Dorsey argues that, as a group, they have produced good results: “They represent a persistent approach to generating excess returns and protecting capital in down markets,” he says. “They are not benchmark-driven and we don’t restrict what proportion in cash managers can have, and some have more than others.” Most of the managers have a track record spanning more than a decade.
While investors can clearly pick a particular manager’s strategy, or indeed combine a number of managers, one product that the firm has launched is an innovative way of combining the expertise of all the managers to produce portfolios that they argue have an attractive risk/return profile. Dorsey argues that with 70% of the volatility of the benchmark and a beta of 0.7, its flexible all-cap strategy should be an attractive proposition for pension funds. The internal multi-manager setup also has the advantage over external multi-managers in that it means one liquid portfolio of securities and a single, rather than a double layer of fees.
Clearly, combining the portfolios of 20 managers can be done in a variety of ways. The most obvious would be to equally weight each manager’s strategy. However, the strategies have very different risk profiles so an equally weighted combination by value would not be equally weighted in terms of the contribution to the overall portfolio’s volatility. Neuberger Berman’s approach is instead based on a modification of risk parity: manager weights are determined so that their contribution to the portfolio’s downside risk is generally equal.
This is achieved by first computing each manager’s downside volatilities and the correlations of their excess returns. What matters is the co-variance and variance of managers’ excess returns during months of negative market performance. Managers’ weights are inversely proportional to their downside volatilities and correlations. Larger allocations go to managers with smaller downside volatility and correlations, and vice versa.
Neuberger Berman sees the advantages of a modified risk parity portfolio relative to an equally-weighted portfolio as an improved excess returns profile and increased diversification with reduced idiosyncratic risk, downside capture and tracking error. It finds the model portfolio’s hypothetical outperformance over the Russell 3000 benchmark index can be attributed to both the managers’ performance and optimisation.
Dorsey explains that at the top of the process sits the CIO and an investment committee that reviews the 20 flexible all-cap equity managers and identifies their styles and biases. This committee also oversees the portfolio positions and the risk management and the manager allocation model and process.
The next stage is to create an investment portfolio from each manager’s strategy that can be used in the modified risk parity allocation process. This is undertaken by first identifying a suitable composite portfolio for each equity manager. The top 40 largest equity holdings for each manager are then used as input for the portfolio allocation. Cash and bond investments are aggregated as two separate holdings. Manager weights are then allocated for equal risk contributions to total portfolio variance (TPV). This is done by comparing each manager’s downside volatility and correlations to other managers.
The variances (downside volatility) and co-variances (correlations) are aggregated into a TPV measure and each manager’s contribution is identified. Manager weights are constrained to a maximum of 10% of the total portfolio - although they may temporarily exceed 10%, due to performance. The portfolio is rebalanced monthly - although if the stock position for any manager changes by 200bps or the cash for any manager changes by 200bps, it triggers a rebalancing intra-month. The manager weights are reallocated quarterly, using the modified risk-parity model.
The final portfolio typically has 250-500 positions (it currently has 370, according to Dorsey) and the largest individual equity position is typically below 5%. The average manager ongoing security turnover (annualised) is 45% while the quarterly reallocation security turnover is 18%. The portfolio currently has 8% in cash and 8% in bonds, although equity-only versions are available. While the average manager tracking error is around 7-8%, according to Dorsey, the total portfolio’s tracking error is lower than this, and excess returns are positively skewed.
So far, the strategy has found an early major investor that has committed $400m (€270m). Clearly, Neuberger Berman is hoping that this is just the start. Smaller institutional investors may find a one-stop shop, with 20 different strategies covering the whole US marketplace combined in an efficient manner, an attractive proposition. Larger schemes may just find the risk reward profile an attractive proposition in its own right, given the firm’s history of performing well across asset classes if the firm can deliver what it promises.