active management among asset classes than active manager A, who is using security selection to achieve the same IR. In Equation 2.1, any of the variables can be solved given the value of the other two.
An extension of FLOAM provides additional insights into the potential value-added properties of TAA. FLOAM assumes that the manager is unconstrained in the sense that she can apply her skills to all available securities. In reality, portfolio managers face a number of constraints, both internal and external. For instance, the manager is constrained by the limits imposed by SAA. In addition, there could be regulatory constraints on allocations to certain asset classes. Finally, there are implementation costs associated with active management. This is particularly important when considering alternative investments. The costs associated with changing allocations to private equity or some real assets could be prohibitive. Even altering allocations to more liquid segments of alternative investments, such as commodity trading advisers (CTAs) and some hedge fund strategies, could be costly. The next section models potential costs.
2.1.2 FLOAM and the Cost of Active Management of Alternatives
Unlike traditional asset classes, most alternative assets are not actively traded, whether they are held directly or held through investment pools. Even investment pools with liquid underlying assets (e.g., CTAs and long/short equity hedge funds) are typically not liquid. Therefore, there are costs associated with actively managing portfolios that consist of alternative assets. This section introduces implementation costs into FLOAM.
The FLOAM as expressed in Equation 2.1 assumes that the manager faces no constraints in the asset allocation decision. If one were to take into account that some allocations may have to be substantially different from the ideal allocation recommended by the manager's forecasting skill, an extended FLOAM can be rewritten as:
where TC is the transfer coefficient. TC measures the ability of the manager to implement her recommendations.10 The upper limit for TC is one, and the lower limit is zero. When TC is equal to one, it means the manager is able to implement all her recommendations. Clearly, TC will be less than one when a portfolio of alternative asset classes is considered. Both hard constraints, such as no short selling of funds, and soft constraints, such as high transaction costs associated with the rebalancing of alternative assets, will reduce the value of TC well below one.
APPLICATION 2.1.2
Consider two similarly skilled active managers, each with an IC of 0.50. Active manager C can apply his skills to only 16 asset classes, whereas active manager D can apply her skills to 100 securities. What level of transfer coefficient does each manager need to have in order to generate an information ratio of 1.2?
Using Equation 2.2:
Active Manager C:
Active Manager D:
By having greater breadth, active manager D can achieve an IR of 1.2 with a TC of only 0.24.
2.1.3 Costs of Actively Managing Portfolios with Alternatives
Either as a result of monitoring or stemming from the desire to actively manage a portfolio of traditional and alternative assets, an investor may decide to redeem a fund or change allocations among funds. Even if the manager lacks the skill to forecast returns, such reallocations could provide benefits if the monitoring process has unveiled certain concerns about the manager. For example, the manager may have deviated from his original strategy or the fund may have experienced significant outflows, reducing his ability to spend the resources needed to manage an institutional-quality fund. While there may be benefits to redemption or rebalancing, there are also associated costs. The most important costs in actively managing a portfolio of funds are forgone loss carryforward opportunities and costs associated with liquidation and reinvestment: dormant cash, opportunity losses, and slippage from transaction costs and market impact.
2.1.3.1 The Cost of Forgone Loss Carryforward
The forgone loss carryforward is potentially borne by every investor in a fund with an asymmetric fee structure. Forgone loss carryforward arises when an existing investor loses the fee benefits of owning a fund below its high-water mark. The cost to the investor results from a managerial decision to liquidate a fund. Because a manager collects performance fees only when net asset value (NAV) is above the most recent high-water mark at the end of the relevant accounting period, a manager who is underwater (i.e., whose net asset value is below the most recent high-water mark) does not accrue performance fees until a new high-water mark is achieved.
The cost of loss carryforward should be taken into account when the decision is being made to replace a poorly performing manager with another manager. Going forward, the return realized from the poorly performing manager will be gross of performance fees, while the return earned on the investment with the new manager will be net of performance fees. This means the new manager will need to outperform the old manager by the amount of the performance fee just to break even. If the drawdown of the current manager is large, investors collect gross of fee returns for several periods. For example, if a manager experiences a drawdown of 25 %, then the next 33.3 % return (0.75 × 1.333 = 1.0) generated by the manager is passed on to investors gross of performance fees. Assuming a performance fee of 20 %, the new manager has to earn 41.67 % [0.333/(1 – 0.2) = 0.4167] for the investor just to break even.
While the loss carryforward represents a potential cost for replacing a manager that has recently experienced some losses, there are four reasons that an investor may still wish to replace a manager with a carryforward loss. First, the investor may be concerned that the manager does not have an adequate incentive to generate performance until the high-water mark is reached. That is, because of the lack of incentive on the part of the manager, the recent poor performance may continue for some time. Second, in the absence of a performance fee, the management fee alone may not be enough for the fund to retain its best traders and maintain its risk management and compliance infrastructure. Therefore, the fund may no longer represent an institutional-quality fund. Third, other investors may withdraw their funds, making the investor's relative position in the fund too large. Most investors want to avoid this situation, because if they decide to redeem their shares in the future, the fund's NAV and operations could be adversely affected when a relatively large part of the assets under management (AUM) is redeemed. Finally, the investor may wish to reallocate away from the poorly performing manager because he believes the fund's strategy is no longer attractive. Whether based on the investor's decision to replace a manager or the manager's decision to liquidate the fund, the investor suffers a historical loss from paying incentive fees on profits that were lost and a prospective loss from not being able to earn future profits without paying incentive fees while the fund returns to its net asset value.
2.1.3.2 Four Other Costs of Replacing Managers
One important cost associated with replacing a poorly performing manager was discussed in the previous section. There are four other costs associated with replacing managers, none of which are affected by the past performance of the managers. These include forgone interest on dormant cash, forgone excess returns on uncommitted cash, administrative costs of closing out one position and opening another, and the market impact of liquidating one position and starting a new position. The common factor driving the first two costs is that there are several leads and lags when making a decision to take money from one
