Leveraging Your Manager’s Best Ideas: MCAs and the Role of Partnership in Dynamic Portfolio Management
The formal study of finance teaches fundamental hypotheses and theories to explain market behavior as well as techniques for portfolio construction. Direct experience and the wisdom of those who have been there before us can teach us the limitations of those tools and how ruthless a bear market can be. Both types of study enhance our knowledge and thoughtful allocators may additionally benefit from partnering with skilled asset managers who can provide them with market insight that may assist with efficiently allocating capital and weathering inevitable market storms. A goal of this paper is to provide institutional investors with a better understanding of how these partnerships can be leveraged through the Managed Custody Account ("MCA") structure and how it may be utilized to improve governance, allocation decisions and performance of their portfolios.
The efficient market hypothesis provides an excellent foundation for understanding the challenge of beating an index of publicly traded securities. It is less valuable in explaining both positive and negative extremes in market pricing which seem to be better explained by behavioral finance and it is limited in addressing private markets which are increasingly making up larger proportions of institutional investor portfolios. Another pillar of institutional portfolio management is Modern Portfolio Theory which creates an exceptional mathematical foundation for constructing mean variance optimized portfolios. However, it requires the input of future expectations for returns, volatility and correlations of any asset class included in the optimization analysis. Unfortunately, reliable and accurate insight into the data inputs required for mean variance optimization is somewhat rare, so the job of asset allocation remains challenging and allocations are sometimes more reflective of the recent past than the relative values of the present day. "
Research has shown that our ability to forecast the optimization inputs is dismal," said Dr. Arun Muralidhar, Adjunct Professor of Finance at George Washington University and Chairman and Chief Investment Officer of AlphaEngine Global Investment Solutions. "Ignoring this concern, the variables themselves are dynamic, yet MPT models use static inputs. Even if we perfectly forecast all variables, the time needed for these variables to converge to their true value is 40 years and we are thus trading on noise."
Before Dr. Eugene Fama described efficient markets and Dr. Harry Markowitz proposed portfolio optimization, Benjamin Graham was providing insight into the discipline of investing. In The Intelligent Investor, which has been described by Warren Buffet as the best book about investing ever written, Mr. Graham provides a framework for the emotional discipline needed to succeed as an investor as well as analytical tools for thoughtfully making investment decisions. He acknowledged that the characteristics of an investment portfolio are usually reflective of the type of investor or investment objective established for the portfolio, but took issue with the idea that the rate of return targeted by an investor was directly related to the degree of risk that they were willing to bear.
Mr. Graham believed that the rate of return sought by an investor should be dependent upon the amount of "intelligent effort the investor is willing and able to bring to bear" to the task of investing. He taught that higher returns were more possible for a disciplined, thoughtful investor than by a passive investor and was a proponent of the relative value concept across asset classes, arguing that an undervalued equity may represent less real risk and greater upside than a conventional bond. The concept of relative value and informed decision making is the foundation for dynamic portfolio management.
The leading proponents of dynamic portfolio management seek to understand the degree to which various markets are efficient, but also embrace the insight of Mr. Graham with regard to risk and relative value. Some asset classes have indices, commonly used as benchmarks for the asset class, which demonstrate a high degree of efficiency. An example of this would be the S&P 500 or the Russell 1000 as a proxy for large cap US stocks. Long term outperformance of these indices by managers building portfolios of their subcomponents is rare due to high levels of transparency and near instantaneous dissemination of information regarding component companies. The internal efficiency of these indices makes them excellent candidates for synthetic exposure when rebalancing.
However, the efficiency of an index does not necessarily prevent an asset class from becoming significantly over or undervalued relative to historical standards. When the downside risk of owning broad exposure to an asset class or its index proxy is not adequately compensated, the informed investor should avoid or reduce exposure in favor of other assets in the portfolio offering greater relative value. Interestingly, almost every portfolio has the built-in capacity to accommodate such shifts as their investment policy usually has ranges around asset class targets within which the portfolio is permitted to reside. An awardwinning paper documents how a public pension plan has been able to improve overall returns by 1% p.a. for over 10 years through dynamic rebalancing.1
Active managers who are putting forth the "intelligent effort" described by Mr. Graham in fundamental equity and credit analysis are often a valuable source of insight into relative value at the sub-asset level. Managers focused on traditional areas of analysis such as contractual returns and discounted cash flows often have more disciplined processes with regard to the prices that they are willing to pay for assets. This price sensitivity could help inform the asset allocation process for institutional investors, but they often lack a governance structure that allows them to work in a flexible manner with asset managers who could provide insight.
Typically, investors allocate capital to a single investment strategy or fund at a time. The manager usually has a fiduciary obligation to that specific investment fund but has no obligation or incentive to advise the client regarding investing or rebalancing into other strategies in which the manager may also invest. Under an ideal investment structure, a manager would utilize their insight regarding relative value to assist their investor clients in growing and protecting capital through informed rebalancing and would be compensated on the basis of the value they add across the entire relationship.
In a low-yielding environment when many funds are being forced to lower their expected returns, institutional investors are under increasing pressure to generate returns in excess of an assumed rate. Finding innovative ways of redefining the traditional relationship between allocators and managers could play a significant role in enabling outperformance or even meeting the target rate of return. This idea of a relationshipbased structure and compensation agreement is the foundation of the MCA structure.
An MCA is a relationship based agreement that seeks to:
- Create a governance structure that allows the investment team of an asset allocator to work more efficiently with an asset manager;
- Make the asset manager a fiduciary to the asset allocator at the relationship level instead of at the individual fund/asset level;
- Enhance alignment of interest between the asset allocator and the asset manager, usually through a fee netting agreement which increases compensation for the manager based on the success of the overall relationship rather than the individual sleeves or investments; and
- Reduce contracting time and costs for both the asset allocator and asset manager by capturing key terms in the MCA agreement and dramatically reducing the contracting burden for future investments under the MCA structure.
The MCA structure creates a template for establishing strategic partnerships between asset allocators and asset managers. The governance structure that is created through the MCA agreement may be tailored to the specific needs, infrastructure and staffing of the investor/allocator and should detail the recommendation, review and approval process that will be followed by the manager and allocator’s staff. It may also define specific investment decisions that the manager may exercise on a discretionary basis and whatactions require review and approval from the asset allocator and who has the authority to approve investment decisions. Generally, it is the introduction of this increased flexibility in the governance structure that is perhaps the most powerful and beneficial aspect of the MCA agreement for an institutional investor. Making the manager a fiduciary at the relationship level is a key tenet of the strategic partnership and affords the asset manager and investor the freedom to work together in a more unified fashion toward the goals, objectives and best interests of the investor. A manager who serves strictly as a fiduciary at a fund level may feel obligated to seek to maximize returns at just the individual fund level. For example, the manager who experiences a modest price decline on stable assets that he or she expects to recover is unlikely to sell those assets to take advantage of a greater opportunity in another strategy whereas a manager serving as a fiduciary across multiple strategies may have far greater flexibility in seeking to maximize risk adjusted returns across the relationship.
Agency issues and seeking to increase the alignment of interests are some of the most critical and challenging issues faced by an institutional investor. These issues drive extreme scrutiny of contracts and create numerous questions that the institutional investor must answer before moving forward in a new investment. Why is the manager creating this strategy now? Is the manager simply seeking to increase their assets under management with this strategy or is it their best idea to drive returns? Gleaning the answers to these questions requires a deep understanding of the manager, the strategies involved and the investment environment. While many investors have successfully navigated these issues, a more straightforward solution can be found in the fee netting agreements of most MCAs. With the fee netting agreement, the path to greater rewards for both the asset manager and investor is clear -- high stable compounding returns. MCA fee netting creates a split of the asset growth of the relationship between the investor and the manager.
The contracting cost and time savings driven by utilizing the structure may also be significant for both managers and investors. Under traditional contracting, an investor with a broad relationship to a manager across multiple strategies may go through a contracting process with that manager numerous times over a ten-year period. The MCA agreement defines allowable strategies for the relationship as well as all side letter terms for the agreement. Additional fund and direct investments that fall within the guidelines of the structure typically require no additional contracting. Changes to the structure or guidelines may often be made with only minor amendments to the agreement. The hallmarks of the MCA structure may reduce that entire process to a single contract, saving tens or hundreds of thousands of dollars per relationship for both the investor and manager.
The Texas Tech University System endowment has implemented a substantial number of MCA relationships across its portfolio and has realized the benefits these structures can provide. "We can attest that the concept is adding substantial value to the overall endowment," said Tim Barrett, Chief Investment Officer of the Texas Tech University System. "Some of the 'best ideas' of our managers held in separate accounts are outperforming the funds 4:1 over the last few years."
Despite the myriad benefits of the MCA structure, it is not without its challenges. Investors need to find managers who they believe can and are willing to communicate valuable market insight. They also need to have confidence that the manager can provide strong relative performance across multiple strategies or structures. These allocators also need strong investment teams capable of quickly reviewing and evaluating investment recommendations within the framework of their asset allocation targets and relative opportunities.
"Allocating a larger portion of a plan’s assets to multi-strategy managers under an innovative fee structure requires a more in-depth diligence of a prospective manager’s overall business strategy and business management capabilities than might be the case in a single-product allocation," said Allan C. Martin, Partner at NEPC, LLC, one of the industry’s largest independent, full-service investment consulting firms.
The structure also increases reporting complexities and creates an additional fee calculation waterfall. While managers are often willing to provide the additional reporting and fee calculations, governance best practices would recommend the use of a third party administrator that can addressthe operational complexities inherent to MCAs to ensure data integrity and accuracy in the measures that matter. This may include the verification and reconciliation of assets and valuations, performance monitoring, fee calculations and consolidated reporting.
"It is critical to have a third party track the performance of the hedge funds, drawdown funds and separate account performance, in addition to the fee savings," Mr. Barrett added. "A third party administrator is imperative in order to effectively communicate performance and fee savings to one’s governing board."
Managers also face a number of challenges with MCAs. Fee netting across multiple teams and strategies requires buy-in for the structure at the highest levels of the firm and a sometimes slower or escrowed payout schedule. The manager needs to contract for sufficient discretion under the structure to add value and generate strong returns or have confidence in the allocator’s investment team and their ability and skill to act as a valuable partner. These challenges may drive managers to restrict the establishment of the MCA to only large institutional investors or those with the proven experience and infrastructure to support the structure.
Despite these challenges, the MCA structure remains an innovative tool for creating strategic partnerships between asset managers and investors. The MCA affords institutional investors access to investment managers' best ideas and highest performing strategies under a construct that improves the alignment of interests between both parties. By using MCAs, sophisticated investors have the ability to dynamically allocate capital and generate stronger risk adjusted returns that will benefit them, their sponsors and the ultimate beneficiaries of those institutional investment programs. With management and performance fees calculated at the aggregate level across all investments, managers are similarly incentivized to share responsibility for optimizing allocations across their own strategies and offerings. Leveraging the best ideas of managers may be a simple way to improve portfolio level returns in the current low-yielding environment.