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  • Brian Schroeder

Does Market Segmentation Add Value?

Updated: Jan 22

(NOTE: The Spreadsheet download is at the bottom.)

OCIOs (and investment consultants) claim to add value through strategic and tactical asset allocation. Otherwise, why hire them? So far in my 12+ years of reviewing them, I have never seen one document if and how much value they add via these two strategies.


Diving deeper into this topic is the skill of market segmentation. Within a broad asset class, how well do they allocate between sub-asset classes? For example, how well do they allocate between Large Cap, Mid Cap and Small Cap within the domestic equity market? How well do they allocate between International Developed and Emerging Markets? For fixed income, how well do they allocate between foreign/domestic or investment grade/high yield?


Since most portfolios are managed following a market segmentation or "slice and dice" approach, it is essential to learn if value is being added or lost compared to a broad market index. If you don't find out, you are truly flying blind and may be quietly losing value.


DOMESTIC EQUITY: Large Cap / Mid Cap / Small Cap


I have done countless due diligence reviews of investment consultants and OCIOs that invest with numerous domestic equity managers such as Large Cap Growth, Large Cap Value, Mid Cap Blend, Small Cap Growth & Small Cap Value. Some even slice it finer with Microcap, "SMID" and additional stylizations like "concentrated core," "deep value," momentum and GARP. The presumption is that market segmentation, usually with active managers, will create more value than holding a broad domestic index like the Russell 3000.


Not only does segmenting assets into many smaller mandates create greater complexity, but it will greatly increase costs, especially when using specialty managers. What plan sponsors need to know is does segmentation, greater complexity and increased costs add value above and beyond a broad market index?


This is how you can quickly and easily get the answer. All you need is your strategic asset allocation weightings within your domestic equity allocation and the weighted average fee you pay in each sub-asset class. Download the spreadsheet below and enter the data; the spreadsheet updates itself. It's as easy as 1-2-3! Here is how it looks.


For this example, I chose fairly normal allocations and reasonable fees. Fees can be higher or lower depending on the managers used and thus can impact the outcome. So be very precise in your data entries to ensure you get the most accurate results.

Since 2010, the segmented portfolio underperformed the index by 59 bps per year and only beat the market index 2 of 12 years. For a $100M allocation that equates to over $7,300,000! Further, the segmented portfolio had a higher standard deviation, making it a less efficient portfolio. In this particular example, it may be a good idea to fire all domestic managers and simply buy a broad index at the cheapest price.


BUT WE USE ACTIVE MANAGERS AND TACTICAL REBALANCING!


The analysis compares market beta and is rebalanced monthly. The higher fees from active managers are supposed to result in excess returns. But that is another question and should be quantified separately. If the OCIO or investment consultant can demonstrate that they can consistently pick active managers that create aggregate alpha greater than any market segmentation loss, then a case can be made to maintain the status quo. The reverse could also be true in that market segmentation adds value while active management loses value.


An OCIO or investment consultant could also claim that they add value with rebalancing, and that such value-add cannot be realized without market segmentation. Again, this is another question that needs to be quantified separately. If it can be documented their rebalancing prowess indeed adds value, it must be added to the equation to determine if market segmentation, with or without active managers and tactical rebalancing, is better than owning a broad market index.


WHAT ABOUT FIXED INCOME AND INTERNATIONAL EQUITY?


This same analysis can be applied to other broad asset classes such as fixed income and international equity. Just get the data and create your spreadsheet. Or you can hire OCIO Monitor to perform this objective analysis to ensure your method of investing is matching your strengths and weaknesses to maximize portfolio efficiency.



Market Segmentation Analysis
.xlsx
Download XLSX • 39KB


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