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INVESTMENT OUTSOURCING
HOW MANY MANAGERS SHOULD YOU USE?
Investors who outsource the management of their portfolios often wrestle with determining the
optimal number of external asset managers to employ. This issue is relevant for a wide variety
of investors, from the largest retirement plans and sovereign wealth funds around the globe to
foundations and high-net-worth individuals. To help investors address this question, we have
established a simple framework that takes into consideration the benefits of manager diversification
along with related costs.
THE THEORETICAL APPROACH
Robert Gyorgy
Client Investment Officer,
Northern Trust
Multi-Manager Solutions
The theory of portfolio diversification teaches two things:
1. The risk/return trade-off of a given portfolio can generally be improved by considering a
larger number of assets.
2. The composition of the portfolio with the least amount of risk for any particular level of
expected return (the so-called minimum-variance portfolio) depends on the expected returns,
the variances and correlations of those returns and the number of assets.
We can take a similar approach by applying the theory of portfolio diversification, with its factors
of expected returns, risk and correlations to the question of how many managers to employ in a
given portfolio.
Understanding how diversification affects active risk is a good start. Exhibit 1 presents the
relationship between the number of managers and the total level of active risk within a portfolio.
A portfolio’s active risk is defined as the annualized standard deviation of the monthly difference
between the portfolio return and the benchmark return. Note that active risk arises from positions
taken relative to the benchmark portfolio.
EXHIBIT 1: Manager Diversification Reduces Active Risk
3.5%
3.0%
Active Risk
Patrick Groenendijk
Senior Client Investment
Officer, Northern Trust
Multi-Manager Solutions
2.5%
2.0%
1.5%
1.0%
0.5%
0%
1
2
3
4
5
6
7
8
9
10
Number of Managers
Source: Northern Trust
For illustrative purposes only. Not representative of any investment strategy or portfolio.
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Exhibit 1 clearly shows the total level of active risk in the portfolio declines as more managers are
added. However, the marginal active risk reduction declines as the number of managers increases.
The information ratio provides a useful way to assess the risk/return trade-off in the portfolio.
The information ratio is defined as the excess return of the manager relative to the benchmark
per unit of active risk. Exhibit 2 shows the effects on the portfolio’s information ratio of adding
more managers. We have assumed all managers have an information ratio of 0.5, implying that
no matter how many managers are included in a portfolio, the next addition is as good as the
first one. We also assume that the manager’s results are uncorrelated, so that with each additional
manager, the risk decreases. This explains the upward sloping line.
EXHIBIT 2: Manager Diversification Increases the Information Ratio
1.8
Information Ratio
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
1
2
3
4
5
6
7
8
9
10
Number of Managers
Source: Northern Trust
For illustrative purposes only. Not representative of any investment strategy or portfolio.
Next, we turn to expected returns. To calculate the expected return of an asset manager,
analysts usually use the expected excess return, which is the extent to which the manager is
expected to outperform the benchmark. The variance of that expected return can be calculated
using historical time series of excess returns. The correlation of the excess returns is often
assumed to be zero, since in theory there should be very little mutual relationship between the
outperformance of various managers1.
In recent years, the active share metric has emerged as a new way to assess active managers.
Active share measures how individual stock weights in a portfolio differ from the weights in a
benchmark, providing an enhancement over traditional measures such as tracking error. The
investment industry has embraced active share as an important addition to the toolkit for
evaluating actively managed portfolios2. Exhibit 3 looks at the active share in relation to the
number of managers in a portfolio. With the addition of each manager, the portfolio will look
more like the benchmark, lowering the active share.
1 E mpirical research has shown that, on balance, the correlation of excess returns appears to be close to zero across asset classes, but nonzero within an asset class. See, e.g.,
Bob Litterman (2003): Modern Investment Management, p. 177.
2 S ee, e.g., Michael Hunstad (2014): “Reducing Your Reliance on Risk Models: Another Look at Active Share”, Northern Trust Asset Management. http://papers.ssrn.com/
sol3/papers.cfm?abstract_id=2512494
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EXHIBIT 3: Active Share Decreases as More Managers are Used
90%
80%
Active Share
70%
60%
50%
40%
30%
20%
10%
0%
1
2
3
4
5
6
7
8
9
10
Number of Managers
Source: Northern Trust
For illustrative purposes only. Not representative of any investment strategy or portfolio.
The theoretical analysis presented in Exhibits 1 and 2 indicates that adding more and more
managers to the portfolio is unequivocally beneficial for the investor. Why, then, don’t investors
use more than a handful of managers in a given portfolio?
PRACTICAL LIMITS
It stands to reason there are practical limits on the number of managers an investor can use in any
asset class. These revolve primarily around fees. Employing more managers may result in higher
fees incurred by the portfolio for two reasons:
1. Most managers offer a fee discount for larger mandates. As a simple example, a manager
might charge 70 basis points to manage the first $50 million and 40 basis points for amounts
above that threshold. Having more managers means the investor is less likely to achieve the
investment threshold amount at which the discounted fee applies. The investor’s bargaining
power over fees can also diminish if the investor has smaller mandates to award. Hence, on
average, the investor will pay higher fees across the portfolio.
2. Many managers charge minimum fees to manage an account. Particularly for investors with
smaller portfolios, using more managers might result in the minimum fee being applied
more often.
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Exhibit 4 presents the effect on the total level of investment manager fees of adding more managers.
EXHIBIT 4: Manager Diversification Increases the Total Fees
Number of Managers
Total Investment
Management Fee Across Portfolio
1
0.43%
2
0.50%
3
0.58%
4
0.65%
5
0.69%
6
0.73%
7
0.74%
8
0.75%
9
0.76%
10
0.78%
Source: Northern Trust
The manager fees are calculated as follows: 0.80% on the first $25 million; 0.65% on the next $25 million;
0.50% on the next $25 million; 0.35% above $75 million.
For illustrative purposes only. Not representative of any investment strategy or portfolio.
An often overlooked consequence of adding more managers is the increased variable cost of
custody, administration, performance measurement and manager monitoring.
■■ Custody: The custody costs usually depend on the number of accounts. Since each manager
requires a new account line, having more managers increases the custody costs.
■■ Administration: Every manager incurs costs for a number of administrative tasks such as
billing tasks and legal reviews. As an investor uses more managers, more of these services are
required, implying higher administrative costs.
■■ Performance measurement: Performance measurement becomes more complicated (and
hence costly) as more managers are added to the portfolio, especially if there are intra-month
cash flows in and out of manager mandates.
■■ Manager monitoring: The cost of manager monitoring directly depends on the number of
managers, as each manager requires separate monitoring. While the monitoring could be
outsourced, that would also come at a cost.
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Exhibit 5 shows how the total cost of custody, administration, performance measurement and
manager monitoring can potentially increase depending upon the number of managers.
EXHIBIT 5: Manager Diversification Increases Various Other Costs
Number of Managers
Custody/Administration/Performance
Measurement/Monitoring Cost
1
0.045%
2
0.070%
3
0.095%
4
0.120%
5
0.145%
6
0.170%
7
0.195%
8
0.220%
9
0.245%
10
0.270%
Source: Northern Trust
We assume a flat 0.02% custody/ administration fee for the portfolio and a 0.025% performance
measurement/monitoring fee for each manager.
For illustrative purposes only. Not representative of any investment strategy or portfolio.
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COMBINING THEORY AND PRACTICE: THE OPTIMAL NUMBER OF MANAGERS
If we combine the theoretical benefits of manager diversification (reduced active risk, increased
information ratio and reduced active share) with the practical limits (cost) we have outlined, it is
possible to determine a range for the optimal number of managers to use. Exhibit 6 presents the
information ratio of a portfolio, both before and after costs, for various numbers of managers.
EXHIBIT 6: The Optimal Number of Managers
1.8
Information Ratio
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
1
2
3
4
5
6
7
8
9
10
Number of Managers
Before Costs
After Costs
Source: Northern Trust
For illustrative purposes only. Not representative of any investment strategy or portfolio.
ILLUSTRATIVE EXAMPLE
Let’s consider a $300 million developed equity mandate. To simplify the analysis, we make the
following assumptions:
■■ Benchmark is the MSCI World Developed Markets Index.
■■ The managers considered have the following characteristics:
—— Each fund has a 3% tracking error and a 0.5 information ratio.
—— Each holds 25 stocks equally weighted.
■■ Zero correlation between the outperformance of the managers.3
■■ No holdings overlap among the managers.
■■ Managers are equally weighted.
■■ Costs for custody, administration, performance measurement and monitoring of the mandate
equal 0.02% plus 0.025% per manager.
■■ Managers are compensated according to the following commonly used tiered fee schedule:
—— 0.80% on the first $25 million;
—— 0.65% on the next $25 million;
—— 0.50% on the next $25 million;
—— 0.35% above $75 million.
■■ The investor does not want the active share of the portfolio to drop below 60%.
3 In manager research, the goal is usually to find managers with negative correlation. Combining positively correlated managers decreases the diversification benefits and results
in a lower optimal number of managers. While negative correlation is optimal, we use zero correlation in this example for the sake of simplicity.
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1.8
1.8
1.6
1.6
1.4
1.4
1.2
1.2
1.0
1.0
0.8
0.8
0.6
0.6
0.4
0.4
0.2
0.2
0.0
0.0
EXHIBIT 8: The Optimal Number of Managers Needed to
Reach an Active Share of 60%
Active Share
Information Ratio
EXHIBIT 7: The Optimal Number of Managers Based on
Information Ratio (illustrative example)
1
2
3
4
5
6
7
8
9
10
Number of Managers
Before Costs
90%
90
80%
80
70%
70
60%
60
50%
50
40%
40
30%
30
20%
20
10%
10
0%0
1
2
3
4
5
6
7
Number of Managers
8
9
10
After Costs
Source: Northern Trust
For illustrative purposes only. Not representative of any investment
strategy or portfolio.
Source: Northern Trust
For illustrative purposes only. Not representative of any investment
strategy or portfolio.
The accompanying figures present the results of the analysis when applying these assumptions.
As depicted in Exhibit 7, adding more managers provides enhanced performance until costs are
taken into account. In Exhibit 8, we show that in this highly simplified example for a $300 million
developed equity mandate with a target active share of 60%, the optimal number of managers
would be four or five.
SUMMARY
We maintain the belief that adding managers reduces active risk, provided managers can be
found that have positive expected returns and low correlation to existing ones. In practice,
however, adding managers comes at a cost. Custody, administration, performance measurement
and manager monitoring all become more expensive as the number of managers increases.
Depending on the investor’s circumstances, an optimal number of managers can be found by
thoughtfully addressing this trade-off.
Yet for institutions and individuals with limited assets, implementing a portfolio with an
optimal number of managers often is not feasible given the costs involved. In such a situation, an
investment outsourcing (OCIO) provider can offer a practical solution. By negotiating with asset
managers, custodians and other vendors, the OCIO provider can achieve economies of scale that
contribute to a cost-effective implementation option, even for smaller asset pools.
FOR MORE INFORMATION
To learn more about investment outsourcing, please contact your relationship manager
or visit northerntrust.com.
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INSTITUTIONAL INVESTOR USE ONLY – NOT FOR USE WITH RETAIL INVESTORS.
Past performance is no guarantee of future results. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest
directly in any index. There are risks involved in investing including possible loss of principal. There is no guarantee that the investment objectives of any fund or strategy will be
met. Risk controls and models do not promise any level of performance or guarantee against loss of principal.
This material is directed to eligible counterparties and professional clients only and should not be relied upon by retail investors. The information in this report has been obtained
from sources believed to be reliable, but its accuracy and completeness are not guaranteed. Opinions expressed are current as of the date appearing in this material only and
are subject to change without notice. This report is provided for informational purposes only and does not constitute investment advice or a recommendation of any security or
product described herein. Indices and trademarks are the property of their respective owners. All rights reserved.
© 2015 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the U.S. Products and services
provided by subsidiaries of Northern Trust Corporation may vary in different markets and are offered in accordance with local regulation. For legal and regulatory information
about individual market offices, visit northerntrust.com/disclosures.
Northern Trust Asset Management is composed of Northern Trust Investments, Inc. Northern Trust Global Investments Limited, Northern Trust Global Investments Japan, K.K, NT Global
Advisors, 50 South Capital Advisors, LLC and personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.
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