Challenging groupthink: Willis Towers Watson says most active managers over-diversify to reduce investment risk
“Knowing more about less”: this is how Willis Towers Watson describes the process of researching fund managers. “There are 18,000 asset managers. There are more asset managers than there are stocks in indices,” says Chris Redmond, head of manager research at Willis Towers Watson. “We cannot possibly devote our time to every one of them.”
The London-based investment consultancy spends a gruelling 150 hours investigating each new manager, on average.
Willis Towers Watson is one of the “big three” investment consultancies, alongside Mercer and Aon Hewitt. Together, they are the gatekeepers to major institutional capital, advising pension schemes, insurance companies, and sovereign wealth funds on where to invest their money.
Willis Towers Watson currently manages USD170 billion of delegated assets, and its advisory asset base extends to over USD2 trillion.
A key aspect of Willis Towers Watson’s approach to manager research is the search for difference. As investor Sir John Templeton put it: “If you want to have better performance than the crowd, you must do things differently from the crowd.”
But difference can be hard to find, in an industry pervaded by ‘groupthink’.
Redmond says the most striking example of groupthink in the industry is the current tendency for active asset managers to over-diversify their portfolios.
Diversification has famously been called the “only free lunch” in investing, allowing investors to spread their risks across multiple companies, sectors, and regions.
“What we’ve found is that the average manager runs with somewhere between 80 and 150 stocks,” says Redmond. “Practically, what that means is that they like 30 things, and then they hold a bunch of other stuff for the purpose of risk management.”
The trend is not limited to equities. Redmond says: “Quite surprisingly, that exists in public equities, that exists in credit, that exists in hedge funds, and the overall level of risk taking has fallen.”
Reducing risk ensures that a manager doesn’t underperform, “or, to be quite frank, outperform by too much” in any single quarter, according to Redmond.
“There's been a move towards greater benchmark hugging and careful downside management, and that probably means that while managers still have skill, the chance of them achieving their actual objectives have fallen. I think they'll outperform, but they probably won't achieve what you actually want them to achieve.”
Willis Towers Watson’s research finds that only 30 per cent of active equity managers actually outperform their benchmarks, after subtracting fees.
This goes against a common argument used to defend active management against the rise of cheaper passive vehicles: that active managers charge higher fees because they deliver better performance than their benchmark indices, especially in periods of market turmoil.
Investors have been shifting money out of active management into passive funds in recent years. According to data provider EPFR, passive equity funds have seen inflows of more than USD2 trillion over the past ten years. Over the same period, investors withdrew more than USD1.5 trillion from active equity funds.
Diversification by fund managers has been driven partly by regulation that aims to protect retail investors. The popular UCITS fund structure requires managers to diversify their investments, allowing a maximum 10 per cent of a fund’s net assets to be invested in securities from a single issuer.
“If given a choice between a UCITS fund and a different legal structure, we'd probably pick the non-UCITS version,” says Redmond.
However, the tendency to try and reduce risk has also coincided with many asset management firms starting to sell their equity on public and private markets.
“I do think that the management of asset management enterprise risk is now influencing the way they take investment risk,” says Redmond.
He explains: “The gig of a listed entity is to grow, and ideally grow in a way that doesn't have too many surprises, and doesn't have too many nasty downturns.”
“So, [asset managers] don't want to spook their clients, because their clients might fire them, which might mean that their revenue goes down, which means that the public market punishes them, and their stock goes down.”
Willis Towers Watson is pushing back against over-diversification across the board.
Its institutional clients allocate capital across dozens of funds over a long time horizon, which means that if one of its funds falls 10 per cent in a month “quite frankly, it doesn’t matter that much”.
“Our solution there is to say, ‘We would like you to just own the 30 things that you actually know and like’. Now, [asset managers] are deeply concerned about that, because they have to publish their track record, and their track record will be volatile and all over the place, because that's the nature of doing that. But over the long term, in our experience it actually results in significantly better outcomes,” says Redmond.
Willis Towers Watson has also become “bolder and bolder” in propelling its own views on capital markets into the product development stage.
It collaborates with asset managers and asset owners at an early stage to design innovative products that suit these views. This is de-risked by the firm’s outsourced CIO business, which accounts for around a tenth of its overall client assets.
“We sit in a very privileged seat, in that we hear all of it. We've got thousands of managers beating down our doors with their best ideas, and we've got really strong engagement with our clients to understand what they need, what fits for them, and what they like,” says Redmond.
“Our job is to synthesise that, and then overlay our views. If we do that well, we can really stand on the shoulders of giants.”
Redmond identifies China and sustainability as two current areas of focus for Willis Towers Watson.
The firm is “very positive” on macroeconomic tailwinds for investing in China, including its high labour market productivity, ongoing economic growth, and the opening up of its capital markets.
“I think a key challenge is how we access that, whether it's exclusively via public equities, A shares or all-China, and how we access that in a way that doesn’t fall foul of sustainability issues that are very, very front and centre,” says Redmond.
“At the moment, we're largely just in equity, and we'd like to look at other assets within China we could potentially access.”
Earlier in the year, Willis Towers Watson has upped the target China allocation of its delegated portfolios to 10 per cent of growth assets in the near term. At the time, it noted that investors’ China allocations tended to be between 3 and 5 per cent, despite country’s capitalisation being closer to 20 per cent of the market.
Passive investors’ allocations are continuing to rise steadily with the inclusion of China A-shares on global indices such as MSCI Emerging Markets Equities Index and FTSE Russell Emerging All Cap Index.
Willis Towers Watson has historically been ahead of the curve for asset allocation, having favoured higher allocations to private markets, including debt, equity, infrastructure, and real estate. Data from Preqin shows the dramatic rise of private markets, which have tripled in value since the Global Financial Crisis in 2008, from USD2.5 trillion to USD7.7 trillion in 2020.
“I would guess that the equity and public equity allocation of our average Willis Towers Watson client might be half to two thirds the size of the average,” says Redmond.
Another major area in need of innovation is sustainability in mainstream asset classes.
ESG funds have surged in popularity in the past few years, and Morningstar predicts that half of all European passive funds are likely to be branded ESG by 2025.
“Everyone can do climate tilted indices, they can do screening, they can do tilts, but it all feels a little bit more marginal. Everyone's kind of doing the same thing, and in reality, I suspect none of them are really aligned with a 1.5 degree warming world,” says Redmond.
While innovative sustainable investment opportunities abound in real assets and private markets, from renewable energy to social housing, and forestry, the real challenge remains in finding mainstream assets with sustainability characteristics.
“That means rather than doing really cool things in the 10 per cent of the portfolio where we deal with more esoteric and unusual ideas, we can make real progress in the big building blocks, where you've got 20 or 30 per cent of your capital allocated,” he says.
The “status quo bias” that exists in public equities has only started to break in recent years. ‘Old World’ companies, including mining, energy, and tobacco continue to dominate mainstream indices such as FTSE 100. This is beginning to change, with Bank of America finding that clean energy companies now trade at a 70 per cent premium to traditional energy peers.
“The market didn't price sustainability risk until three years ago. We, as a society and as a financial market, mispriced the externality of emissions,” says Redmond.
With environmental issues now on investors’ radars, Redmond says more attention should be paid to diversity and inclusion. Diversity and inclusion has struggled to gain traction outside of the firm’s US client base, where Redmond says there has been a “real ramp up”.
It is also a cultural issue for the asset managers that Willis Towers Watson researches. Last year, Willis Towers Watson analysed more than 2,000 investment teams globally and found that diverse teams outperformed those with no gender or ethnic minority employees by an average of 20 basis points a year.
Redmond says culture is one of the “most common” stumbling blocks for asset managers in the research process.
“Certain cultures do breed groupthink because they're not diverse or particularly inclusive, and they rely on a close-knit group of people who've been thinking about the world the same way for the last 10 years. Suddenly, the market is going to price sustainability risk properly, and they’re going to need to change their models,” says Redmond.
Willis Towers Watson assesses the culture of an asset management firm by spending a full day with the C-suite, in order to gauge how aligned the managers are with their clients and employees.