1Demystifying Multi-Managers

Extracting the best out of managers

– high conviction portfoliosThese days it isn’t enough to invest with a number of investment

managers, and receive the diversification benefits. Clients now

demand more from their investments, which in turn requires

further commitment from investment managers to delivering the

best outcome for investors. One way to extract the most out of

managers is the use of high conviction portfolios.

What is a high conviction portfolio?

High conviction portfolios contain holdings of securities that an

investment manager believes will have the highest expected return,

in essence their best ideas. As a result, high conviction portfolios

are expected to generate a higher level of return than a manager’s

standard portfolio.

A high conviction portfolio typically comprises large holdings of

a relatively small number of stocks. An investment manager will

therefore pay little attention to country, industry and stock

weighting relative to an index benchmark when constructing this

type of portfolio. As a result, the expected risk or volatility of the

portfolio is also higher.

The diagram opposite indicates how a high conviction portfolio

compares to a manager’s standard portfolio on the risk / return space.

Edition 3

DemystifyingMulti-Managers

There has been a lot of interest in ‘multi-manager’

investing recently, as advisers, researchers, platforms

and, importantly, investors recognise the important

risk-reduction that can result from diversifying a

portfolio across a range of investment managers.

Whilst the benefits of diversification across different

investment managers (and asset classes) are

appreciated by most advisers, what is less clear are

the important differences between the various forms

of multi-manager investing, and the impacts on both

clients and advisers.

This article follows on from earlier articles, and

considers how to get the best out of managers within

a multi-manager solution, by using ‘high conviction

portfolios’. We explain what these are, why they

are useful, and emphasise the importance of the

relationship between MLC and the manager when

using these types of mandates.

Expected Risk

Investment manager’sstandard portfolio

Investment manager’sconcentrated portfolio

ExpectedReturn

2 Demystifying Multi-Managers

Why don’t all investment managers offer highconviction portfolios?

Because a high conviction portfolio typically holds a smaller number

of stocks, it can exhibit significant volatility when compared to a

broad index benchmark (eg S&P/ASX300 Accumulation Index or

MSCI All Countries World Index) and other managers. The resultant

degree of volatility of investment returns will not be acceptable to all

investors, particularly if they allocate all or a large part of their

investment strategy to such a high conviction style.

In addition to increased volatility, most managers fear being too

different from their peers due to the associated business risk. For

example, if an investment manager’s fund returned negative 10%

when their peers funds returned similar negative results, the risk of

them losing business is mitigated – they do not stand out from the

crowd. However if they returned the same result while their peer

returns were positive, and if this pattern persisted even for a

relatively short period of time, the threat of the manager losing

investor funds is heightened.

Managers are generally forced to create their ‘standard’ offers as

through the investor holds just their funds, and doesn’t want the

extra volatility associated with a high conviction portfolio. This is

because the manager does not know how an investor and/or adviser

are using the fund within a client’s portfolio, and must assume an

investor is investing in solely their fund.

In order to reduce this business risk, individual investment managers

broaden their portfolio security holdings in their standard public offer

funds to dampen volatility and ensure they do not differ too much

from the index or competitor funds. This means that they maintain

exposure to a range of securities with a high weighting in an index

for risk control purposes, rather than a strong belief in their future

expected return (eg News Corporation Limited and National Australia

Bank Limited, which form a large part of Australian indices).

MLC, on the other hand, encourage our investment managers to pay

less attention to their business risk and build high conviction discrete

mandates for our investors. That is, MLC encourages managers not

to hold stocks such as News Corporation and National Australia Bank

if they don’t think the security is going to increase in value.

The diagram below illustrates how a standard portfolio may differ

from a high conviction portfolio

However, because high conviction portfolios typically have a lower

number of stocks than standard portfolios, the volatility of the

portfolio (compared to an index) also increases.

How does MLC control this volatility?

MLC can reduce the portfolio volatility on behalf of investors, by

blending a number of complementary high conviction managers

together in a multi-manager strategy, without reducing expected

investment returns.

The diagram below illustrates that MLC is able to reduce this extra

volatility by combining high conviction portfolios managed by a

broad range of specialist investment managers who are individually

exceptional but who have different and complimentary investment

styles. The well-diversified MLC multi-manager portfolio can

therefore reduce risk substantially.

The result is a portfolio that has a higher expected return than just

blending a manager’s standard portfolio, as often done by many of

new multi-manager offerings within the market.

Stocks the manager likesStocks the manager holds to reduce

business risk, and reduce the risk of

performance divergence from the selected

index, can be considered as ‘padding’

Standard Fund High Conviction

Tracking error

Expectedexcessreturn

3Demystifying Multi-Managers

The MLC Australian Share strategy

To illustrate the degree of variation from the index in MLC’s high

conviction portfolios, both at individual manager and at a

consolidated level, we will examine the Australian share asset class.

MLC uses seven Australian share managers whose discrete MLC

mandates are combined to form the overall MLC Australian share

portfolio. Having seven excellent but different managers means that

no one manager can materially disrupt the overall performance of

the MLC portfolio if their style is out of favour, they are unlucky or

they simply got a few calls wrong.

The individual manager portfolios very in size in terms of the

number of stocks; they range from as few as 30 to more than 140.

Importantly, when the seven portfolios are consolidated to form

MLC’s Australian share portfolio, the result is a broadly diversified

portfolio containing approximately 240 stocks (as at 31 May 2004)

which represents a collection of the highest conviction ideas from

each of our seven managers.

The following chart shows the proportion of each of our incumbent

managers’ portfolios that are different to the index. This is simply

the sum total of all their active overweights in their portfolio at each

point in time (ie in effect this is their cumulative bet against the

index). An investment manager aiming to replicate the index should

have minimal active money in their portfolio and therefore be

expected to track along the 0% line in this chart.

As you can see from the above diagram, the MLC Australian share fund is between 25-30% active compared to the index.

You are unlikely to be able to construct portfolios in this manner

without using individually managed mandates. Off the shelf

investment options offered via a fund of funds, master trust or

wrap accounts are designed as investments in their own right and

therefore may not be tailored to be part of a high conviction multi-

manager portfolio such as MLC’s. That is, portfolios created from

manager’s standard offering are likely to have a lot less ‘active’

money, and have a lower active proportion of the fund’s investments.

MLC Australian Equities Strategy - Active Money vs ASX300

0%

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100%

Jan-03

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Jul- Aug-03

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Date

Active Money Relative

Concord

Contango

CSAM

Lazard AE

Jardine

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MBA

MLC AE

4 Demystifying Multi-Managers

This advice is intended to provide general information only and has been prepared by MLC Limited (ABN 90 000 000 402) without taking into accountany particular persons objectives, financial situation or needs. Investors should, before acting on this information, consider the appropriateness of thisinformation having regard to their personal objectives, financial situation or needs. We recommend investors obtain financial advice specific to theirsituation before making any financial investment or insurance decision. MLC Limited, 105-153 Miller Street, North Sydney NSW 2060, is a member of theNational group of companies.

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How does MLC gain access to high conviction portfolios?

In summary

Once MLC Investment Management has identified a manager that

they believe has a sustainable competitive edge (which can be the

culmination of several years of MLC researching a manager), they

work carefully with that manager to ensure the MLC portfolio is a

pure reflection of that manager’s best ideas.

It is often difficult to convince a manager to run high conviction

portfolios as this can either take the manager outside their comfort

zone (ie they personally feel uncomfortable running higher conviction

portfolios) or their business model is such that they do not wish to

run multiple strategies.

MLC convinces managers to run high conviction portfolios on behalf

of our investors by:

• Having sufficient scale to make it commercially viable for the

manager to offer a unique individually managed portfolio to MLC.

With in excess of $45 billion dollars in funds under advice, the

allocation to each of our incumbent managers is substantial

(typically in excess of A$1 billion) and therefore can justify the

additional attention required to manage such portfolios. High

quality international managers will generally not accept individual

mandates for less than US$50 million which is beyond the

means of most Australian investors.

• Entering into sophisticated discussions with the manager in

which we demonstrate that their high-conviction portfolio will not

significantly increase the riskiness for investors due to the overall

MLC multi-manager portfolio.

• Demonstrating that we truly understand what we are buying,

how this may behave throughout a full market cycle, and as such

prove that past performance does not drive our manager hire/fire

decisions. In doing so, we can point to many such example over

our history of managing managers in this way since 1986.

Platinum and Maple-Brown Abbott are two such examples having

experienced an extended period of soft performance during the

mid to late 1990’s then subsequently rebounding strongly.

• Suggesting that new investment managers we employ confirm

our credentials by speaking to our other managers.

This article has discussed MLC’s use of high conviction portfolios.

We learned how MLC works with our investment managers to

ensure that these mandates are designed to ensure that each

investment manager has the scope to fully express their views and

insights, and as such get the most from their competitive edge.

MLC is able to use these discrete high conviction investment

mandates through:

• sufficient scale to justify the additional attention required of the

manager to run such mandates,

• a close relationship with our managers and a deep

understanding of their skill and faith in their ability,

• experience gained in multi-manager portfolio construction

since 1986, and a long-term and forward looking focus.

The resulting consolidated MLC portfolios are unique and contain

the best ideas of a number of different investment specialists which

improves the long term wealth creating potential for MLC investors.