Harnessing 'active edge': combining managers
28 September 2020 | Portfolio construction
By Conor Hafner, senior investment product specialist, Vanguard Europe
Human judgment is central to active fund management. Cost may be the most likely driver of long-term outperformance, but only a talented manager can make the complex decisions that drive success in an active strategy in terms of delivering alpha. In our last blog, we explored the active edge that a talented manager brings to a given strategy. Here, we will talk about when and why we combine two or more managers in a single fund.
Sometimes, particularly in the case of equity strategies, a combination of different managers in a single active fund can produce a well-diversified portfolio with a lower level of active risk1, which is measured by a fund’s tracking error.
Research has shown that the average investor return is higher in well diversified funds as there are generally fewer, or shorter periods of underperformance2. Combining managers with distinct yet complimentary styles means it matters less what style is in favour at any given time.
Using qualitative and quantitative metrics, we combine managers with different investment styles and characteristics. For example, combining small firms with large firms and concentrated portfolios with diversified portfolios; each with an individual manager who has a different investment process and source of alpha.
Take the Vanguard Global Equity Fund for example, which has a broad objective to deliver capital growth from a portfolio of global equities. Since inception in 2016, it has been managed equally by Baillie Gifford’s Global Alpha team and Wellington Management’s Opportunistic Value team.
The Vanguard Global Equity Fund
Wellington’s Opportunistic Value team was once led by the late, legendary John Neff, who ran a Vanguard’s flagship US equity strategy from 1964 to 1995 with a distinctive contrarian value style that remains rooted into the team’s philosophy, now led by David Palmer.
What makes the Opportunistic Value team really stand out for us is their autonomy within the wider firm. Wellington does not have a chief investment officer, instead it operates as an organisation of teams, which promotes a culture of partnership and entrepreneurship. This structure lends itself to original thinking and collaboration across specialisms.
Baillie Gifford’s Global Alpha team is led by Malcolm MacColl, Charles Plowden and Spencer Adair. They seek what they see as meaningful investments that will fund genuine business growth. The team believes it can make money for clients by assessing a company’s prospects for sustainable growth, rather than by trying to predict its short-term share price movements.
Part of the Global Alpha team’s active edge is its differentiated approach to growth investing that is balanced and doesn’t preclude any sector or stock type. The managers categorise holdings as either rapid growth, latent growth, cyclical growth or growth stalwarts. Another side to the team’s active edge is their conviction in the quest for ‘multibaggers’, stocks that grow by over 100%. This affords the managers scope to tolerate losses in some positions that can be more than offset by one successful holding.
The Global Alpha team tends to hold stocks for the long term, which results in a much lower turnover compared with the Opportunistic Value team. While the Opportunistic Value team is very mindful of downside risks, the Global Alpha team accepts some losses in pursuit of stocks with multibagger potential.
The contrasting styles and approaches of the managers enhance the diversification of the portfolio through a broader mix of stocks, with only five out of 203 holdings owned by both managers3, and a lower combined tracking error over three years relative to the benchmark of 3.13% compared to 4.27% and 4.69% for the individual portfolios3.
The Vanguard Global Emerging Markets Fund
Another example of how we combine managers is our Global Emerging Market Fund, which is managed equally by three different managers, including Baillie Gifford, Oaktree Capital Management and Pzena Investment Management. The fund seeks to deliver capital appreciation over the long term from a portfolio of equities in companies based in emerging markets (EM) around the world.
Baillie Gifford’s EM equity team is led by Mark Gush, Andrew Stobart and Ewan Markson-Brown. The team employs a similar ethos to the Global Alpha team and leverages the deep research capabilities within the firm to find long-term, sustainable businesses with high growth potential in emerging markets.
Bringing a value-led approach is the EM equity team at Pzena, led by Allison Fisch, Rakesh Bordia, Caroline Cai and John P. Goetz. The team follows Pzena’s classic value investment philosophy, which seeks strong businesses at low valuations. They focus on companies that are underperforming their historically-demonstrated earnings power and apply intensive fundamental research to these companies in an effort to determine whether the problems that caused the earnings shortfall are temporary or permanent.
Oaktree Capital’s EM equity strategy is led by Frank Carroll, who employs a style-agnostic approach with a focus on risk-adjusted returns. The team places the highest priority on preventing losses. It is their overriding belief that, especially in the opportunistic markets in which they work, ‘if we avoid the losers, the winners will take care of themselves’.
In short, each of the managers have different ideas and approaches when it comes to EM equity. When combined in a single fund, the differences result in a broader mix of stocks and reduced volatility. For example, 125 out of the 156 holdings in the fund’s portfolio are unique to one of the three managers, with 28 securities held by two managers and only three names held by each manager4. The combined fund also has a lower three-year tracking error of 3.59%, compared to the three separate portfolios (4.7%, 4.06% and 5.45%, respectively).
Combining managers is something we have done since 1987 and we believe it’s an approach that has the potential to continue to deliver long-term value to our investors. We only combine managers that have distinct styles, different ideas and where there is likely to be a limited overlap of holdings.
We don’t use a multi-manager approach for all of our active funds though – a single-manager strategy may be used for specialised funds and will often involve a long-term strategic partnership. We will look at our single-manager strategies later in this blog series. The next instalment of which will cover how Vanguard approaches fixed income through active management strategies.
1, Active risk or tracking error refers to the volatility of an active fund relative to the target benchmark
2, Morningstar research, ‘Mind the Gap 2020’
3, 4, 5, Vanguard, using data from Factset, as of 30 June 2020.
Investment risk information:
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future results.
Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.
Investments in smaller companies may be more volatile than investments in well-established blue chip companies.
The Fund may use derivatives in order to reduce risk or cost and/or generate extra income or growth. The use of derivatives could increase or reduce exposure to underlying assets and result in greater fluctuations of the Fund's net asset value. A derivative is a financial contract whose value is based on the value of a financial asset (such as a share, bond, or currency) or a market index.
Some funds invest in securities which are denominated in different currencies. Movements in currency exchange rates can affect the return of investments.
For further information on risks please see the “Risk Factors” section of the prospectus on our website at https://global.vanguard.com.
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