How the best active managers can play multiple positions in a diversified portfolio.
This article first appeared in the February/March 2011 issue of Morningstar Advisor magazine. Get your free subscription here.
Basketball has five defined positions, but coaches often like to put their best players on the court even when it requires players to take on hybrid roles that cut across the traditional positions. Taken together, the team will have the skills necessary to cover the court, but players are free to play their game, wherever that may take them. The team is taking advantage of the unique individual talents of its star players.
We at Morningstar Associates think of this analogy when we use active managers to put together multimanager investment portfolios for clients. There are several defined positions in a well-diversified portfolio. In our diversified domestic-equity portfolios, for example, we want to cover the main positions of the Morningstar Style Box. One approach would be to simply select one manager--a pure position player--to cover each square of the style box. But if our goal is to put together the most successful team, we want to think more broadly about how to combine successful active managers in a way that allows us to benefit from their skill while still achieving the diversification benefits that come from covering the style box.
Selecting the Best Players
To do this, we first determine which managers we want to employ. We like active managers who have a well-defined investment process based on rigorous fundamental research that has stood the test of time and that we believe is repeatable into the future. We prefer managers who are willing to express in their portfolios the conviction they have in their process. In many cases, our preferred managers are those we've closely observed for years.
Once we've selected our managers, we determine how we're going to combine them in a portfolio. To do that, we first analyze the holdings of all the managers, plotting them in the style box. This gives us a style blueprint for each manager. What we typically find is that few active managers are truly pure position players, at least as defined by the style box. Most have holdings that plot into multiple squares of the style box. Moreover, those few who are pure players tend to be low-tracking- error, index-hugging managers who often have difficulty outperforming passive funds over the long run. They seldom are the stars.
As an example, take a look at the style blueprints of four active large-cap mutual funds that are Morningstar Analyst Picks: Sound Shore
Using this information in our portfolio-construction process, we can determine how much we need to allocate to each manager in order to hit our overall allocation targets. In so doing, we recognize that our best managers are contributing to several positions, but that, overall, our portfolio is achieving its diversification goals and doing so with managers who have proven they can use skill to add value.