Capital Allocation/Manager Selection
Because BBH utilizes a fundamental, bottom-up investment approach, we do not set targets for sub-asset classes based on macroeconomic views and predictions about price movements and asset class correlations. Instead, we search for talented managers to partner with for the long term. We refer to this process of selecting and sizing managers as “capital allocation,” which forms the foundation for our policy portfolios.
In seeking talented managers, we look across sub-asset classes. In equities, we look for managers that invest in U.S., international developed and emerging markets equities across the capitalization spectrum. We also search for managers that invest in privately owned and distressed companies as well as real estate. Within fixed income, we invest across a range of securities, including Treasuries, corporates and asset-backed and other structured products, as well as loans to private companies (direct lending). What differentiates our approach from many other wealth managers is that we determine sub-asset class weights largely based on our ability to identify talented managers to partner with that have an opportunity to generate attractive long-term returns. Importantly, we would rather forego investing in a specific sub-asset class than invest with a manager that does not meet our standards.
Perhaps the most differentiated part of BBH’s process is the strict investment criteria with which we evaluate and underwrite new managers for client portfolios. Our article “BBH’s Approach to Manager Selection” discusses IRG’s approach to selecting and partnering with external managers. Once a manager is approved, the sizing of the position is based on a separate set of criteria, a selection of which we describe next.
Among the most important pieces of criteria we consider in sizing a position are the expected risk, return and diversification benefits a manager provides. To gain a good understanding of these factors, we look at a manager’s specific opportunity set and conduct deep due diligence to understand its strategy on a granular level. This deep research allows us to ascertain how a manager’s strategy will affect the risk and return of client portfolios. As an example, IRG’s decision a few years ago to allocate capital to a manager that originates loans to lower middle-market companies was based on the quality of the manager, its experience investing in private debt and its ability to provide attractive expected returns with strong downside protection. While IRG considered general characteristics of the sub-asset class (direct lending), these favorable characteristics of the manager drove the capital allocation decision.
Another factor that we analyze closely before allocating capital is concentration of holdings. Before assigning a portfolio weight to a manager, we consider what that weight implies for the position sizes of individual equity holdings in the portfolio on a look-through basis. For example, a manager with an 8% weight and an average position size of 10% and a manager with a 5% weight and an average position size of 15% would both have positions that are roughly 0.80% on a look-through basis.
Along with the consideration of other factors, including the manager’s capacity, liquidity profile of the underlying investments, level of transparency into the manager’s holdings and fees and fund structure, IRG will establish weights to the various managers, which then roll up to sub-asset classes and, ultimately, to equity and fixed income targets.
The process by which we finalize portfolios, marrying both the bottom-up and top-down elements of our asset allocation and capital allocation processes, is referred to as “portfolio construction.” In this part of the process, we utilize top-down risk management tools to determine whether our bottom-up decision-making process has resulted in unintended concentrations in key risk exposures. Accordingly, any key risks identified in the portfolio construction process may prompt us to reconsider our initial manager/sub-asset class weights. In describing BBH’s asset allocation process, we say, “We invest bottom-up and worry top-down.”
We perform several analyses in the portfolio construction process, but arguably the most important is what we refer to as portfolio “guardrails.” With guardrails, we regularly monitor key portfolio exposures at the underlying security level2 on factors such as individual holding concentration, manager concentrations, liquidity, leverage, currency, geography or more nuanced exposures like credit sensitivity or commodity risk. Because we put so much emphasis on individual managers, this process is a key risk control that allows IRG to measure portfolio-level risk exposures.
Geographic concentration, for example, is a risk that we measure by looking at the country of domicile for each security in each manager’s portfolio. By looking at the security level as opposed to the asset class level, we can gain a more nuanced picture of our exposures, since not all managers invest 100% of their assets in their “assigned” asset class. We classify BBH Core Select, for example, as U.S. large-cap equity, but the strategy holds American depositary receipts (ADRs) of companies domiciled outside of the U.S. Similarly, some of our non-U.S. developed equity managers hold positions in companies domiciled in emerging markets, and our global equity managers have exposure in several world equity markets.
Some numbers help to illustrate the different picture that emerges of our portfolios when looking at the asset class vs. the security level. At the BBH asset class level, we can only distinguish between U.S., non-U.S. developed, emerging markets and global equity. At the security level, however, we can analyze the portfolio at a more granular level. For example, at the end of February 2019, the largest exposure within the public equity portion of a BBH Growth Model Portfolio3 was the U.S. at 54%, followed by the U.K. (9.0%), Switzerland (5.6%) and 10 other countries that each had over a 1% weight. Our largest two emerging country exposures were India (1.9%) and Brazil (1.3%). Looking at some of the other measures, BBH’s largest industry exposure was software and services (14.8%), our largest currency exposures were the U.S. dollar (70.9%) and euro (9.6%), and our largest equity holding was Berkshire Hathaway (2.5%).4 Having up-to-date analyses of these exposures is crucial to understanding the real risks in our portfolio and allows us to make changes to manager allocations if these exposures are out of acceptable ranges.