Wednesday, June 2, 2010

The Problems with Getting to Neutral

Pinnacle’s investment team is contemplating neutral risk…again. As we have often written, “neutral risk” or “benchmark risk”, is the level of volatility that we think is implied by owning a two asset class benchmark that we use for risk and return. Of course, actual Pinnacle portfolios own as many as twenty different asset classes and specific market sectors and industries. Fine tuning the resulting portfolio results can be frustrating. My best guess before last week was that our portfolios were slightly overweight benchmark risk, with our estimate of “equity like” exposure in our moderate portfolios at 68% versus the benchmark of 60% risk as measured by the S&P 500 Index. However, last week we beat the benchmark on every down day in the market, a result that was unexpected. The returns of our Gold ETF and The Hussman Strategic Growth Fund helped to support portfolio returns even though we were theoretically “overweight” volatility on a relative basis. For the record, we will be sellers of risk if the S&P 500 Index falls below 1,044 on a closing basis, and even though our “equity like” exposure will still be above benchmark on paper, we think we will probably be slightly underweight volatility on a relative basis.

James Montier, one of the industry’s great thinkers and a brilliant writer, who is now with GMO Investments wrote a white paper this month on the problems with benchmarks, called I Want to Break Free, or, Strategic Asset Allocation ≠ Static Asset Allocation. I have railed on about benchmarking issues in this space forever, but as always, Montier says it better. Here are a few quotes from his paper about the problems with benchmarking (I don’t have the space to quote his entire comments for fear of breaking my rule about blog length, but here are a few selected comments from Montier on the subject):

Problem 3: Benchmarking alters behavior… benchmarking tends to alter investment managers behavior along three important dimensions. First, managers motivated to compete against an index may lose sight of whether an investment is attractive or even sound in an absolute sense. They focus upon relative, not absolute, valuation.

Second, as soon as you give a manger an index, the measure of “risk” changes to tracking error: how far away from the benchmark are we? …For benchmarked investors, the risk-free asset is no longer cash, but the index that they are compared against.

Finally, benchmarked managers start to think about return in a relative sense as well. I’ve always hated the idea of sitting in front of a client having lost money, but claiming good performance because I’d just lost less than an index. That very concept sticks in my craw as an investor.

The bottom line to us is that, effectively, everything becomes relative (risk, return, and valuation) in a benchmarked world.

As always, this is great stuff from James Montier.