What exactly is a “sophisticated” investor anyway?

21 Feb 2010

One of the most overused words in hedge fund sales is “sophisticated.”  If we had a nickel for every time a hedge fund marketing sheet proclaimed that a fund was for “sophisticated investors,” we’d be running a hedge fund for, well, sophisticated investors.

But what exactly does it mean to be sophisticated?  This is a question addressed by Jan de Dreu of RBS and Jacob Bikker of De Nederlandsche Bank in a study of Dutch pension plans.  The duo bases its analysis on the fair assumption that “sophisticated” means “not succumbing to behavioural finance biases.”   While many studies have examined behavioural biases in individual in private investors, they write, “much less is known about professional parties.”

They focus their attention on three cues of (the lack of) sophistication:

  • “Gross Investment Rounding” (i.e. choosing asset allocation percentages that end in 5% or 10%)
  • “Lack of Diversification” (basically, the lack of idiosyncratic risk such as that found in alternative investments)
  • “Home Bias” (the tendency to invest close to home, where opportunities are more familiar)

They also examine overall risk as a sign of sophistication, but purposely avoid overall returns since they are beyond the direct control of investment professionals.

Totally “Gross”

Institutional investors such as pension funds tend to use traditional “60/40” or “70/30” splits between equities and fixed income.  While the average numbers across all investors tend to shift slightly each year (see related post), many institutions stick stubbornly to simple proportions like these – ones that end in a zero or a five.

But modern portfolio theory dictates that optimal allocations to various asset classes can and should be dynamic and are rarely nice even numbers like these.  (Although, like a broken clock, we suppose that a “60/40” allocation is correct on the odd occasion).

Consultants and hedge fund sales people know all too well the inertia they face when they argue that optimizers recommend that alternative asset allocations should comprise 40, 50 or even 100% of a client’s portfolio.  Instead of adopting the “optimal” solution, investment committees will often default to something more plausible – say, 10%.  In a sense, they are effectively adding a “career-risk” variable to the optimization.  (After all, idiosyncratic risk has a much greater influence over career than systematic risk).

When they examined nearly 750 Dutch pension funds, they found that the vast majority had policy allocations to equities that ended in multiples of five.  In fact, there even seemed to be a tendency for policy allocations to end in “0”, instead of “5”.

Rather than optimally dividing the remainder of the portfolio between bonds and other assets (alternatives, cash etc.), even the bond allocation percentages seemed pretty engineered…

You don’t need to be a finance Ph.D. to see that such allocations look pretty fishy – suggesting that they were created by humans, rather than portfolio optimizers.

But de Dreu and Bikker also point out something else in these charts: that there is very little agreement on the appropriate allocation to equities and bonds.  “60/40” is by no means the standard allocation.

When they dove into these results further, they found that large (“sophisticated”) funds tended not to use multiples of 5% as much as their smaller counterparts. (chart below created using data in the paper)

One might expect that larger investors might have a lower propensity to use “gross rounding”.  But we were struck by the gradual increase in the gross rounding over time of the largest institutions.  Are they becoming less sophisticated?  And did the small and medium-sized institutions become more sophisticated between 2004 and 2006?

Who knows.  But here’s a theory:  After taking a bath in the equity market, small and medium-sized plans called in the consultants to conduct ALM studies…

Alternative Reality

Okay, so it’s a bit self-referential for us to argue that the use of alternative investments signals “sophistication” and then say that alternative investments tend to attract “sophisticated investors”.  But in any event, de Dreu and Bikker confirm the intuition that large investors tend to hold more alternative investments than small ones.  (chart below created with data from paper).

As you might also guess, funds that did not use gross rounding for policy allocations were twice as likely to use alternative investments.  (We wondered if this is because of greater sophistication or simply because the introduction of a third asset class – alternative investments – simply forces investment committees to tweak their existing gross roundings.)

Home Sweet Home

Finally, de Dreu and Bikker examine whether small or unsophisticated funds tend to invest a higher proportion of their portfolios in Europe.

As you might guess due to their relative lack of investment manpower, smaller funds do indeed invest more in Europe.  But the duo also finds that nearly half of funds that use gross rounding (allocations ending in multiples of 5%), invest in the EMU.  This compares to only about a third of funds that do not use gross rounding – suggesting that “sophisticated” pension funds tend to invest more outside of Europe that their less sophisticated brethren.

The paper includes several other notable observations about the behaviour of different types of and sizes of pension funds.  Assuming the Dutch aren’t all that different from the rest of us, these results should help explain a lot of the frustration faced by consultants and hedge fund sales people as they try to make the case for alternative investments.

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  1. Eric Hirschberg
    March 5, 2010 at 5:16 pm

    Having run an institutional Hedge Fund, it quickly became apparent that the notion of only allowing “sophisticated” investors was really a substitute for not allowing “unsophisticated” investors. This is because the looser regulatory environment did not allow for the same levels of investor protection that could be presumably relied upon under greater regulation and oversight. That said, a common argument used be sophisticated investors when faced with a loss is estoppel. So we are sophisticated until we are wrong, in which case we relied on your “misrepresentation” (so much for the role of Due Diligence!). Lack of regulatory oversight is not congruous with the ability to abdicate ones responsibility for outcome.

    Rather than comparing the skills that constitute sophisticated vs unsophisticated, I prefer to look at the problem from the ski slope prospective. The Double Black Diamond is there to tell you that their is a reasonable chance that you won’t get down uninjured. Your choice of going their is one of your own self assessment and risk tolerance. Double Black Diamonds are the Ski resorts
    attempt at self risk regulation. The Market requirement for sophistication is equivalent to the ski resort saying ” don’t go down this double black diamond if you aren’t wearing skis and holding poles”. I don’t believe it ever implied anything more.

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