Unconstrained Will Get Overdone

Maybe I’ve just had a couple of unusual random draws from the information urn, but it seems to me that unconstrained mandates are getting more favorable investment attention from investment consultants than they used to.  The “style box” is breaking down a little, and I think that is a good thing.

My view of the investing world starts with industries, not market cap size, and not even growth/value.  Much as I end up on the value side, I am flexible on what constitutes value in different industries.  I range from growth at a reasonable price to deep value.  It depends on the state of the industry.

All that said, let me talk a little about what it takes to be a good unconstrained manager.  Organizationally, you have to understand a lot of things better than the rest of the world.  Do you understand the market, factor, and industry cycles, as well as asset level misvaluations? Investors have the choice of the informationless index, which typically does well versus the average active manager.

As consultants analyze unconstrained managers, their models will get stretched.  The more degrees of freedom a manager has, the tougher it is to evaluate them.  If an unconstrained manager made a brilliant tactical move once, can he do it twice?  Three times?  More?

Think of the few market players that got short prior to the 1987 crash.  Aside from Elaine Garzarelli, none were heard from again, and Garzarelli never had a second episode like that in 1987.

It is really tough to come up with significant ideas that will make a huge difference in security returns.  Home run hitters usually do not hit for average.

What I suspect will happen is this: the initial unconstrained managers will do well, but they will reach capacity limits, and lesser managers will put out “me too” products.  Consultants will buy into those products to some degree, and a decent number of them will fail to meet expectations.  The investors hiring the consultants will wonder why they hired them.  If there is no skill to picking unconstrained managers, then why not pick them directly themselves, or just go back to indexes?

I write this as one that mostly manages equities, long-only.  I like having no constraint on market cap, value factors, industry, and country selection.  I like to roam the world in search of value.  I like to concentrate on industries when I have a good thesis.  Why should I have non-economic criteria limiting my choices, if I reason well?

That’s why I like unconstrained mandates.  I run one for upper-middle class individuals, and small institutions.  But every manager will not do well with it, because most investment organizations are not designed to think that broadly.

Thus I expect that investment consultants will revert to the “style box” (or something new like it) once they realize that few managers can consistently generate alpha over a full market cycle whether unconstrained of constrained.  At least with constrained, the variation when they do badly is more limited, which protects the consultant, who also does not want to end up in the fourth quartile, where business is lost.