Structuring Multi-Manager Investments for DC Plans

W E L L I N G T O N M A N A G E M E N T

viewpoints

May

2013

Structuring Multi-Manager Investments for DC Plans

I n t r o D u C t I o n

Defined contribution (DC) plan sponsors face many challenges when constructing an investment lineup for their participants, including:

�Providing an appropriately wide range of investment choices without overwhelming participants;

�Offering high-quality investment approaches while maintaining reasonable plan costs; and

�Balancing the need to replace underperforming managers with the desire to minimize plan disruptions and potentially confusing participant communications.

Increasingly, plan sponsors are addressing all of these needs with multi-manager investments. Among large 401(k) plan sponsors, 14% offer participants a multi-manager investment and 36% are considering offering one, according to the research firm Cerulli Associates.1 While this solution can involve additional operational com-plexities, they may be far outweighed by the benefits, including simplified but more diversified investment options and greater control over costs and manager changes.

In this paper, we explore the practical implications and potential benefits of adopting a multi-manager structure. In addition, we offer a new framework for construct-ing multi-manager solutions that was developed by our Investments and Risk Management Team. The framework is designed to move beyond simple return-based or style-box classification to a risk-factor approach that we believe can provide par-ticipants a more consistent return profile with greater downside protection over time. While the analysis used in this paper focuses on US equity portfolios, the framework has broader application, including to global and non-US multi-manager portfolios.

Jerry Crean

Jed Petty, CFA

About the AuthorsJerry Crean and Jed Petty are senior members of the Defined Contribution Solutions Group. They are responsible for assisting clients with long-term investment strategy and policy issues.

1The Cerulli Report, “State of Large and Mega Defined Contribution Plans: Investment Innovation and the Plan Sponsor Perspective,” July 2012.

GiberM

Professional-Institutional Investors

Wellington Management 2 Viewpoints


what’s Driving Demand for Multi-Manager investments

Interest in multi-manager investments is attributable, at least in part, to the defined benefit knowledge transfer to the DC world that has taken place in recent years. More specifically, DC plan sponsors are finding that multi-manager solutions can help them pursue several key objectives:

Simplify the plan menu while improving diversification ― The sheer size of the typical DC plan menu, which may include 30 or more investment options, does not promote sound investment decisions by plan participants. This problem can be traced to the 1990s, when menus expanded dramatically (the “bull-market architecture”) to include funds specialized by asset class, style, market capitalization, region, and other parameters. In addition to creating anxi-ety in participants faced with too many choices, this menu structure has induced mistakes ― for example, participants investing in four or five equity funds that may vary by style or market cap but will in fact tend to behave the same, espe-cially in periods of market stress (Figure 1).

Multi-manager investments combine options that would oth-erwise crowd the plan menu. More important, they embed institutional-level “best thinking” about diversification in

the plan menu. Increasingly, this entails a greater focus on risk diversification. Rather than selecting managers based on style-box classifications, for example, investors may be better served by combining managers that provide an effective bal-ance of risk-factor exposures.

Implement non-core exposures more effectively ― To help participants improve diversification and pursue specific objec-tives, plans have been adding certain non-core investments to their menus. Examples include commodities, natural resource equities, and other investments that tend to perform well in periods of rising inflation ― a key risk to retirement portfolios. The challenge is that the performance of different inflation hedges will vary depending on the economic environment. Rather than leaving it to participants to calibrate an appropriate mix of these assets, multi-manager investments can provide a single, actively managed solution with less risk of participant misuse of the individual component investments.

Make the process of adding or substituting investments less disruptive ― New managers and approaches can be added to multi-manager investments, or substituted for underperform-ing approaches, without requiring specific action on the part of participants. For example, if existing small-cap approaches in a multi-manager investment become capacity constrained, the plan sponsor can simply add a new small-cap approach to the multi-manager option that complements the existing strat-egies. The need for additional, potentially complex participant communications is reduced as well.

Minimize plan costs ― Multi-manager investments may provide an opportunity to benefit from economies of scale ― for example, if they are offered not just on the self-directed portion of the menu but also as components of custom target-date funds. In addition, multi-manager investments that include institutional vehicles (e.g., separate accounts, commingled pools) may help reduce costs.

implementation Challenges

Multi-manager investments are not without hurdles. For the plan sponsor, these may include additional coordination across providers, including custodians, consultants, and managers, as well as the potential for increased record-keep-ing complexities and costs ― though we think these issues are likely to recede as multi-manager investments become more common. Another factor for sponsors is the potential need for increased oversight. Sponsors must conduct due diligence not just on each individual investment in the multi-manager solution but also on the process of combining them

Figure 1

Strong Correlations Between Equity Styles

One-Year Returns Rolling Quarterly

12/01 12/02 12/03 12/04 12/05 12/06 12/07 12/08 12/09 12/10-60

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Sources: Russell, Wellington Management



(e.g., why a particular combination was chosen) ― a task with which consultants may provide valuable assistance. For partic-ipants, the primary issue may be the lack of publicly available information and data on the multi-manager investment.

In our view, however, these challenges are generally more than offset by the potential benefits of multi-manager investments. The question, then, is how best to construct such investments.

Assessing the traditional Approach to Manager selection

Members of our Investments and Risk Management Team have researched the conventional style-based framework for equity manager selection and found that investors applying it today face two key challenges.

Risk factors are progressively becoming more diverse and extreme, and are likely to stay that way. The list of risk fac-tors driving returns has grown well beyond the traditional

style box (growth, value, and market cap), and now regularly includes momentum, volatility, safety, quality, and liquidity, among others. Figure 2 includes a selected group of risk factors. Each dot represents the return to the respective risk factor for the month (see details on calculation below Figure 2). For the 20-year period prior to 1999, the factor returns behaved within normal bands the majority of the time. However, in more recent periods, not only has there been a significant increase in the frequency of outliers, but there have also been greater extremes in returns. We expect this volatility to continue. What’s more, in the most recent five-year period, stock correlations were higher, which magnified the impact of risk factors and the importance of risk-factor diversification in structuring an “all-weather” multi-manager equity investment.

While one should always be cognizant of “recency bias” (placing greater weight on more recent occurrences) when making longer-term, strategic decisions such as manager selection, there have been a number of structural changes in the capital markets that could take years to unwind,

Figure 2

Risk-Factor Returns are More Extreme

Momentum Value

Risk-factor returns based on quintile 1 to quintile 5 monthly return spread for Barra US long-term model factors.

Sources: Wellington Management, Barra

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leaving the probability of more risk outliers fairly high. For example, the bankruptcy of several investment banks, diminished proprietary trading desks, and lower leverage in the shadow banking system have removed mean-reversion capital. That, in turn, has lessened the effectiveness of financial-system shock absorbers and reduced liquidity. In addition, fundamental investors have experienced signifi-cant net redemptions, while trend-following approaches like global macro strategies, high-frequency trading, and exchange-traded funds have gained share, further stressing the financial system. While this may be less relevant over the long term since risk-factor volatility frequently mean reverts, it can lead to significant drawdowns that are not tolerable for many investors over the short term.

Many existing metrics and analytical techniques fall short in assessing risk factors. In recent years, metrics that assume normality, such as style-box analysis, batting average, P/E medians, beta, and information ratios, have not been as useful in identifying embedded risks or future alpha potential. Our Investments and Risk Management Team has found that traditional metrics like averages and medians matter less than the distribution of risks, perfor-mance behavior, and stress testing. In addition, conventional performance hurdles used to structure equity portfolios (e.g., excess returns greater than 2%) have not been as predictive as expected.

An Alternative Approach: A Risk-Factor Framework

Based on their research, our Investments and Risk Management Team has developed a manager-selection framework that incorporates the following principles:

Risk-factor diversification — Rather than selecting managers based on style-box classifications, focus on better balancing risk-factor exposures (e.g., safety, volatility, quality, leverage, growth, value), which can help ensure that performance is driven primarily by security selection over the long term.

High active-share strategies — High active-share manag-ers have tended to outperform low active-share managers in broadly defined equity categories. Active share is a measure of the difference in holdings between a portfolio and its bench-mark, ranging from 0% (complete index overlap) to 100% (no index overlap); the greater the difference, the higher the active share. Active share may be a key metric in preserving alpha potential in multi-manager solutions and can help avoid the construction of “closet index funds” (see sidebar).

Integrating Active and Passive Management

One key decision when structuring multi-manager portfolios is whether to combine active and passive management. Following are several considerations when blending the two.

�Focus on less efficient markets — To the extent that plan sponsors use both active and passive strate-gies, an increasingly common choice, they may be able to improve the odds of delivering active returns by focusing on less efficient asset classes or more unconstrained strategies. Active managers have more consistently added value net of fees in asset classes typically regarded as less efficient, such as small-cap, emerging equity and debt, and global equities, compared with more efficient asset classes like US large-cap equities or US core bonds. In addition, we find that managers who are more unconstrained (i.e., generate higher tracking risk) have generated higher alpha.

�Focus on high active-share strategies — This is especially important if there are passive alloca-tions within an equity plan. Passive strategies combined with low active-share strategies will resemble a relatively expensive index fund in aggregate, so we suggest getting the most out of an active manager allocation/budget by using high active-share strategies.

�Pair low-volatility passive exposures with the high-est active-share managers — Given that the case for active management in low stock-specific-risk areas is more challenging, another consideration would be combining low-volatility passive vehicles with highly active managers. This may help moder-ate expenses while controlling active manager risk and maintaining high alpha potential.



Less focus on historical returns — There should be flexibil-ity in multi-manager portfolios to allocate to newer strategies (that may not have a track record) or to those that have had poor recent performance but meet conviction, risk-factor, and active-share criteria.

More focus on performance in market tails — Traditional metrics such as information ratios may not be predictive of success or signal how managers perform in market extremes. It is important to emphasize not just how much alpha is pro-duced but when it is produced.

Comparing Risk-Factor-Based and style-Based portfolios

To demonstrate the potential benefits of this framework rela-tive to a style-based approach, our Investments and Risk Management Team created a hypothetical case study that assumed it was year-end 2006 and an investor had been tasked with constructing a multi-manager US equity portfolio. Using a style-based framework as a foundation, the investor focused on selecting managers who had generated strong and consistent alpha in an efficient manner (i.e., demonstrating strong information ratio), while minimizing downside risk.

Figure 4

New Risk-Factor Manager-Selection Framework

*For illustrative purposes only; does not represent a portfolio managed by Wellington Management.

Sources: FactSet, Lipper, Wellington Management

Figure 3

Common Style-Based Manager-Selection Criteria

*For illustrative purposes only; does not represent a portfolio managed by Wellington Management.

Sources: FactSet, Lipper, Wellington Management

Taking into account the market environment and industry standards in 2006, it was next assumed that the process for structuring the portfolio focused on performance hurdles in conjunction with a style-box framework. Specifically, the investor applied the screens shown in Figure 3 and selected a range of strategies across the growth, value, and core cate-gories. One third of the portfolio was allocated to each of the three categories. (This example used our proprietary peer-risk database to conduct performance and holdings-based analysis on each strategy. Additionally, for simplicity, it was assumed that any strategy that met the screening criteria also passed a qualitative assessment of the manager.)

To gauge the results of the risk-factor approach, the same 2006 investment universe was used. Rather than using style boxes, however, investments were selected on the basis of balanced allocations across key risk factors. Specifically, 12.5% allocations were made to each of the eight risk-factor categories in Figure 4. The investor selected up to five strate-gies that met the screening criteria (including active share greater than 80% and others shown in Figure 4) and had the highest exposure to a particular risk factor.

Growth allocation33.3%

Value allocation33.3%

Core allocation33.3%

5-year historical analysis

Excess returns greater than 2%

Top-quartile information ratio

Above-median tracking risk

No more than 100% downside capture

Batting average > 55%

Allocation*Screen Screen

Active share greater than 80%

Non-US less than 15%

Currency sensitivitynot significant

Strategies with topfactor exposures

Ignore returns data

Allocation*

12.5% in each:

Growth

Value

Momentum

Contrarian

Safety

Volatility

Quality

Leverage



As shown in Figure 5, during the five years ended December 2011, the risk-factor-based portfolio provided similar tracking risk to the style-based portfolio, but a better excess return. Critically, the worst excess drawdown was less than one-fifth that of the style-based portfolio.

Why are the behavior and return outcomes so different? Bottom-up attribution analysis (Figure 6) reveals that the risk-factor-based portfolio did not have the excessive cyclical biases, including volatility- and country-based biases, found in the style-based portfolio. Instead, the return contributions of the risk factors were well balanced, allowing the returns of the portfolio to be driven more by manager stock selection.

Implementation of a Risk-Factor Framework

While the example discussed here focuses on a US equity portfolio, the same principles may be applied when cre-ating global and non-US multi-manager portfolios. Of course, there are caveats to such a multi-manager portfolio approach. For example, high active-share strategies tend to be volatile and are more challenging to evaluate than those that hew to a benchmark.

Figure 6

What Were the Drivers? Bottom-Up attribution Gives Us Some Clues

Bottom-Up Attribution Analysis, Five Years Ended 2011

Industry

Growth/Value

Market Cap

Momentum

Other Style

Volatility

CountrySelection

-2.0

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(%) Styled Based Risk Based

Sources: FactSet, Barra, Wellington Management

Figure 5

Comparing the Risk-Factor-Based and Style-Based Portfolios

Performance vs Russell 1000, Five Years Ended 2011Risk-Factor-Based Portfolio Style-Based Portfolio

ExcessReturn

TrackingRisk

WorstExcess

Drawdown

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Sources: FactSet, Wellington Management



For more detail on this analysis, see “Structuring Multi-Manager Equity Portfolios: A New Framework for a Risk-Driven World.”2

That said, many institutions and consultants have already begun the migration to risk-based asset allocation frame-works. Within equities, analysis by our Investments and Risk Management Team indicates there are significant benefits to a risk-based manager allocation framework. Risk-factor returns have become more extreme in recent years, and now have as much impact on portfolios as security selection. Given structural changes in the capital markets, this envi-ronment may be likely to persist.

2https://www.wellington.com/en/publication-page?article_id=442

https://www.wellington.com/en/publication-page?article_id=442

https://www.wellington.com/en/publication-page?article_id=442

http://www.wellington.com/KnowledgeBank/publications/equity/structuring_multi-manager_equity_portfolios_a_new_framework_for_a_risk-driven_world.jsp

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Wellington Management Company, llp is exempt from the requirement to hold an Australian financial services licence (AFSL) under the Corporations Act 2001 in respect of financial services, in reliance on class order 03/1100, a copy of which may be obtained at the web site of the Australian Securities and Investments Commission, http://www.asic.gov.au. The class order exempts a registered investment adviser regulated by the SEC, among others, from the need to hold an AFSL for financial services provided to Australian wholesale clients on certain conditions. Financial services provided by Wellington Management Company, llp are regulated by the SEC under the laws and regulatory requirements of the United States, which are different from the laws apply-ing in Australia.In Japan, Wellington International Management Company Pte Ltd has been registered as a Financial Instruments Firm with registered number: Director General of Kanto Local Finance Bureau (Kin-Sho) Number 428. WIM is a member of the Japan Investment Advisers Association (JIAA) and the Investment Trusts Association, Japan (ITA).

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Structuring Multi-Manager Investments for DC Plans