In layman’s terms, what is ‘commitment efficiency’ and why is it important when we talk about portfolio diversification?
We want to help LPs in assessing the quality of the intra-asset diversification within portfolios of private capital funds. So far, when LPs quantify the impact of diversification, they tend to take only a simplistic view on the relationship between vintage years, geographies, strategies and industries and how they interplay. And, are there diminishing benefits of diversification?
From a risk perspective, portfolios should be evenly diversified over these dimensions, ie, the hoped-for protection of the portfolio should not be destroyed because funds ‘crowd’ in one particular dimension, as often happens with vintage years. Commitment efficiency (CE) measures how evenly funds are spread, thus capturing a portfolio’s resilience against market crises. This assumes that an evenly and widely committed portfolio offers the best protection against unforeseen future developments in the portfolio.
We calculate how quickly portfolios would concentrate under economic stresses, where independence can no longer be assumed, and to what degree these concentrations would make the portfolio go off kilter. A CE of 0 would be the extreme, when the portfolio comprises one fund only (or all funds are entirely similar); a CE close to 1 is the other, theoretical, extreme where the portfolio comprises a large number of funds that are completely different under all scenarios.
Is CE the main measure LPs should look at? What are some other important measures when it comes to diversification?
CE is the measure the LP can control, but there are other important aspects to look at such as the exposure efficiency (XE). CE does not tell us how and when capital will be invested, and the resulting diversification of the funds’ underlying private assets. XE tells us how quickly the fund managers turn commitments into real investments in private assets over time.
However, XE also does not give us the full picture. How the diversification implied by the commitments are reflected in the diversification of the funds’ underlying assets and their development (controlled by the CEOs managing the private assets) that drives the outcome distribution – which can be assessed through the portfolio’s Sortino ratio.
Look at this from a different angle: LPs control CE through primary commitments to funds. They may change CE through secondaries stakes in funds, which can also have an impact on XE. Co-investments, on the other hand, have no impact on CE but can improve XE.
What did you find in your example of applying the CE concept to diversifying a private markets portfolio?
CE is a tool for engineering a targeted level of portfolio protection while avoiding an unnecessarily high number of funds. This allows investors to be more selective and to save expenses for sourcing investment opportunities, due diligence, legal structuring and monitoring. Employing the CE approach, we looked at the question of whether investors should be concerned with over-diversification or whether this is a myth.
How many funds are needed to have a ‘diversified’ portfolio of closed-end funds? Ie, what is the ideal diversification level of a closed-end portfolio?
We assume with ‘ideal’ that you mean an optimum level of diversification. In our case study, the results suggested that the best risk-return profile is achieved with less than 30 funds. This is in line with other studies undertaken by academics and practitioners on portfolio diversification that concluded that it takes around 20-30 funds to adequately diversify a portfolio. CE suggests that beyond a certain point, in practice, investors will find it difficult to add truly dissimilar funds to their portfolio.
Having said this, the diversification story is far more complicated, and we are faced with many trade-offs. For instance, maximising XE with having a high share of committed capital being actually invested in private assets implies a lower CE, as commitments need to follow in close sequence at the expense of vintage year diversification. It may also require an over-commitment strategy, which is constrained by the liquid assets that are available.
Lastly, scale is an issue: even if 30 funds would be sufficient from a risk/return perspective, institutional investors with large allocations to private capital do not get around spreading their commitments over many more funds. Here, for instance, it may not make sense for CE to take fund size as diversification dimension into account. Lastly, does the dealflow pipeline provide funds that fit the desired profile? In many cases, the fit will not be ideal and will require compromises.
What are the most important parameters for LPs when thinking about diversification, and why do/should LPs rely on these dimensions for managing diversification?
We have split the diversification problem into its components CE, XP, Sortino ratio, over-commitment ratio, capital-call-at-risk to manage treasury assets, and size of portfolio. A satisfying diversification strategy is a complicated game, but we have now made the important tools available to LPs to play it well.
Thomas Meyer is offer manager and director, innovation at SimCorp, Richard Ballek is a senior manager and Jeppe Sidenius is a senior software engineer. SimCorp is an integrated investment management firm that supplies tech and data services. Founded in 1971, the firm is headquartered in Copenhagen and is listed on NASDAQ Copenhagen.