Institutional investors like active investing — but not active investment risk. That may sound a bit odd, but in the era of alternative investing, this quirk has introduced an element of portfolio inefficiency.
Through most of the 1980s, stocks and bonds were institutional investors’ principal assets. With advances in investment management technology, diversification had become something of a science. Market values of these mostly public assets were readily available and investors could determine allocations and precisely control factor and other attribute exposures. An unintended overweight of a particular segment of the market, say, large-cap growth stocks, could be offset easily and cleanly with an allocation to one or more small-cap index funds. Institutional investors knew, and could control, their P/E ratio, beta, industry and sector allocations, and so on. All this came courtesy of continuous auction market pricing of portfolio holdings combined with advances in investment science. And trustees prized diversification.
Large allocations to hedge funds and private market investments complicated things for the portfolio analyst. (Investments like private equity or private loans account for 35 percent of public pension assets and more than 60 percent of endowments.) Blind pools replaced portfolios of publicly traded securities.
The nature of investment supervision changed. Identifying unusually skillful alternative-investment managers became the name of the game. Institutional CIOs, increasingly referred to as “LPs” and “allocators,” were investing without knowledge of the particulars of what they would own and learning to live with what they got. Nowadays, institutional CIOs resemble hosts as much as principals.
With the embrace of alts, each investor was free to choose — or invent — asset class descriptions and revise them at will. Some chose to go with five asset classes; others ran with ten or more. This gave rise to a new dimension of subjectivism for the investor. Asset class rhetoric abounded, some quite creative. And as it did, actual market exposures became hazy.
But investors didn’t lose their appetite for diversification. Diversification remained cardinal.
Throughout, large institutional funds’ R-squared, a common measure of diversification or correlation with broad market indexes, typically have remained in the range of 95 to 99 percent. How did the funds bring this about while making blind allotments within fuzzy asset classes? They opted to rely on the law of large numbers, often making more than 100 partnership investments in an attempt to be diversified. Assuming an average of 20 discrete equity interests per partnership, an institution would have 2,000 such interests, each, presumably, with its own strategic motivation, or story if you will. But owing to the blind nature of the process, the pattern of diversification has been, perforce, scattershot. The institutions have largely eliminated nonmarket risk, but only through brute force and the mercy of the law of large numbers.
There is nothing elegant about portfolio construction today. In fact, it seems almost primitive. Institutions own a jumble of equity things — nearly countless, largely illiquid, and beyond their control. And they diversify by using costly managed portfolios, something finance theorists frown upon as not being cost-effective. This is the story of scattershot diversification.
Richard M. Ennis is a former editor of the Financial Analysts Journal, and co-founder of EnnisKnupp, one of the first investment consultants.
