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Guest Contributor: A Perspective on “Entrepreneurial” Managers

The following article was written by Frank Muller, Jr., an executive vice president and head of distribution at Behringer. He also serves as chief executive officer and president of Behringer Securities LP.

In my 30-plus years of investment management experience, I have come to believe that there are four primary influencers of portfolio performance:

1. Fund Managers: I recently read an interesting study—one of many on this topic—that argues that smaller “entrepreneurial” managers tend to outperform their larger (usually brand-driven) counterparts. Set aside the argument that you want multiple managers on your platform with outside companies for obvious reasons. But, just as importantly, you want managers on your platform whose odds of outperforming their market segment are in your favor.

These key concepts apply to the manager selection process:

• Entrepreneurial “smaller” managers tend to outperform their larger, more-established peers over almost any rolling time period—without increasing risk. I could go on for hours about why that is, but suffice it to say that size is an impediment in a world that prizes action above process and analysis. This supposition applies to both public and private investing.

• This small-manager performance advantage may come from the willingness to invest in more “illiquid” market segments—whether public or private. Large managers with their hefty AUM are averse to holding a large slice of illiquid investments; therefore, they tend to underweight these segments. Ironically, it is in these limited-liquidity assets that you may find excess returns.

• Smaller managers tend to hire fewer chiefs and more analysts. In general, the more chiefs there are, the more sluggish performance is. Keep in mind, I am not saying no chiefs—just fewer of them. This allows analysts to get the attention of decision-makers. Biases are more readily challenged and communication is more dynamic when there are less layers of leadership.

• Entrepreneurial managers from smaller firms tend to commit larger, more concentrated allocations into investment strategies they favor. To avoid risk-taking, larger managers tend to spread their bets too thinly. Shunning all risk, as with anything else in life, is actually counterproductive.

2. Strategies: The issue with traditional portfolio construction is multifaceted. Let me explain:

• Globalization and technology have conspired to “connect” all public markets, which is squeezing out the inefficiencies. This not only breaks down the historical correlation relationships we depend upon, it also contributes to the creation of bubbles in areas like currency, liquidity and regulatory—all unintended, but dire consequences nonetheless.

• Investors, notably retirees, are focused on wealth preservation; therefore, risk management is their number one priority, and protecting their purchasing power from inflation runs a close second. Thus, they seek out “diversifiers” that add more capital protection than traditional asset classes.

• All strategies must maintain a yin and yang relationship. The best protection is through a balance of strategies, each with a low correlation to the other.

3. Structures—Open-end (mutual fund), CEF, ETF, UIT

• This is a mutual fund world. Whether they are open end, closed end, ETF or UIT structures, a larger percentage of U.S. liquid wealth is invested in these structures. All other regimes are little more than a sideshow compared to this major player.

• Each fund structure has attributes that produce differing risks and benefits. For example, open-end funds only price once daily; they are subject to daily capital inflows and outflows and generally do not provide any tax efficiencies. Closed-end funds are permanent capital structures that are not subject to daily asset redemptions, can only raise capital during the initial offering period and are usually not considered to be tax efficient. ETFs are generally more tax efficient, but are also continuously subject to outflows and new capital inflows. Unit investment trusts price only once daily, are subject to daily inflows and outflows and are generally tax efficient.

• Matching manager and strategy to the right fund structure is a challenge. In addition, pairing these elements with the type of account is also a key consideration.

4. Channels

• Managers and strategies must have consistent capital inflow in order to dollar cost average. Depending on the channel, capital moves with different timing and granularity.

• Diversifying across channels helps to smooth out a manager’s capital flow across market cycles, increasing their ability to perform.

• Looking for managers with multiple channels of capital is another consideration to evaluate as you think about manager and strategy selection.

I believe that these four areas, in balance with investor goals, combine to form the most broadly efficient mechanism for sustaining and preserving wealth. An investment management platform that seeks to provide entrepreneurial managers, diversifying strategies in the appropriate regulatory structure—across diverse channels of capital—stands the best chance of delivering positive relative portfolio outcomes.