When Active Management Matters

This blog may be a little geeky, but bear with me here. In the March/April Financial Analysts Journal, Roger Ibbotson, along with James Xiong, Thomas Idzorek, and Peng Chen, published an article called, “The Equal Importance of Asset Allocation and Active Management.” For those who don’t know, Roger Ibbotson is a giant in the field of finance. His study evaluated thousands of mutual funds and concluded that the market was responsible for about 80% of fund returns and the rest of the return was equally attributed to portfolio policy or active management. Portfolio policy is the same as the portfolio’s benchmark asset allocation. So yours truly, ever on the lookout for studies that minimize the importance of active management, marches into the office of Michael Kitces, our Director of Research at Pinnacle, and says, “Michael, we have to respond to this.” So Michael agrees, and we pen an article that is published in the prestigious Advisor Perspectives online letter that takes issue with Ibbotson’s paper. Kitces and Solow claim that Ibbotson’s study is flawed, that the universe of managers in the study are not active, and that the technique used to determine portfolio returns, called Style Analysis, has the impact of minimizing the benefits of active management.

Our letter created something of a stir. I personally received a number of congratulatory emails describing how we brilliantly enhanced the case for active management. However, Bob Huebscher, the excellent editor of Advisor Perspectives, forwarded several emails to me that took issue with our article. Some were quite reasonable and well thought out, and some were penned by enraged wackos who felt we had no right to breathe the same air as Roger Ibbotson (I should note that Kitces decided to get married and go on his honeymoon while all of this is going on…it was a great wedding!). Anyway, a few of the letters and my replies were published yesterday in this week’s issue of Advisor Perspectives. For one of the letters, as yet unpublished, Huebscher sends the correspondence to a “referee” who is supposed to figure out if there is any merit to any of this squabbling. The referee, who remains anonymous, is actually quite kind to our point of view and says so in his comments. But he ends with the following thought for Huebscher: “My main problem with their article (Solow/Kitces) is that they keep saying ‘excess returns over and above the market’s returns' (attributable to policy allocation and active management), when of course they mean 'over and above, or under and below.’ It’s a typical example of using language to imply that we can expect managers to add value over a market index, when we know that virtually all studies show that on average they don’t, and that there’s no statistical basis for an expectation that they will.”

So, here it is. Kitces and I obviously failed to make our point since the referee restates the same old tired point of view. He correctly states that there is no statistical evidence to suggest that active managers can outperform a market index. The point of our article is, there is no statistical evidence that they can’t! We believe the best active managers can and do outperform, but investors will always have a difficult time figuring out how to assess the performance results of active managers. I’ll be writing more about this, but it comes under the same old category of me complaining about Pinnacle’s performance benchmarks…again.

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.

How to Crush Your Benchmark Returns

It seems to me to be more than a little ironic that in a 12-month period where Pinnacle has set records for absolute portfolio gains, where our clients are basically thrilled with the recovery of their personal balance sheets, and where portfolios have fully recovered to make new highs since the beginning of the bear market in October of 2007, that I find myself worried about our returns relative to our benchmarks. I have written at length about the vagaries of choosing a benchmark for diversified portfolios, and how outperformance can be made to appear or disappear based on randomly adding or subtracting asset classes from the benchmark portfolio.

Nevertheless, our managed accounts portfolios are trailing their benchmarks in terms of total return for the twelve month period. While this underperformance has occurred with less risk or volatility than the market (our risk-adjusted returns still look great compared to both the S&P 500 and cash), it seems to me that average investors remain focused on short-term returns. Therefore, it bears our scrutiny. With that in mind, I thought I would clear up this relative performance question by sharing the strategy that is most likely to crush our two asset class benchmark (S&P 500 Index and Barclay’s Aggregate Bond Index) going forward.

First, we need to abandon any approach to value investing since market values are a notoriously poor market timing indicator. When focused on shorter-term time horizons, any attempt to evaluate market valuation or the economic cycle is basically a waste of time. Next we need to abandon multiple asset classes in our portfolios and only own the S&P 500 Index in our managed accounts. Since this is the risk proxy in our benchmark portfolio, we will avoid the risk that international stocks, commodities, real estate, and other risk assets will underperform over any short-term time frame. Next, we need to make large asset allocation bets so that we maximize our infallible investment forecasts. Taking the portfolio to 100% cash or 100% equity will enable us to crush the benchmark portfolios at will (as long as we are always correct in our assessment of market direction). Just to be clear, we have no intention of doing any of the above since we believe that it constitutes a high risk, if not foolish, investment philosophy. I just thought it would be fun to see it on paper.

Is it Time to Change the Benchmark?

One of the unfair facts of life for investment managers is that our clients insist on two different unofficial benchmarks for performance comparisons. In bear markets, when stock market values are plummeting, clients insist on comparing portfolio returns to cash. However, in bull markets, when stock prices are roaring ahead of other asset classes, clients want to change their benchmark and compare their returns to stocks. There is of course, nothing overly unreasonable about this state of affairs, at least in the eyes of our clients. Unfortunately, if you believe in managing risk by constructing diversified portfolios that own stocks, bonds and cash (and many other asset classes), you are virtually guaranteed to underperform cash in a bear market and underperform stocks in a bull market. This somewhat depressing state of affairs of having your portfolio underperform in both bull and bear market environments is the result of switching between two different benchmarks. We are seeing this unofficial “changing of the guard” with our clients’ perceptions occur now that the market rally is entering its 6th month.

Clients used to ask the question “how am I doin?” in the context of a massive bear market that took the S&P 500 Index down by 57% to its intraday low in early March. The market topped in October of 2007, and for the record it is still about 35% below its all-time high price. If you care to view performance in the context of the market top to current price, then our portfolio results of minus single digits are either very good compared to stocks, or very lousy compared to cash, where investors of all levels of experience can park their money without paying Pinnacle a fee. On the other hand, the stock market has rallied by 51% since the lows on March 9th, and the +25% gains in Pinnacle’s Dynamic Moderate Growth (DMG) portfolios look fantastic compared to cash, and pretty lousy compared to stocks, where investors of all levels of experience can park their money in an S&P 500 Index fund without paying Pinnacle a fee.

We continue to counsel our clients to view investment results over a complete market cycle. Once you take a step back and look at performance in a time horizon that includes both bear markets and bull markets, you can get a good perspective for how we are managing portfolio performance. Depending on time horizon, Pinnacle’s DMG portfolios have delivered between 200 basis points (two percent) and 600 basis points (six percent) of performance over and above our benchmarks, net of fees and transaction costs. This year we are having a phenomenal year relative to cash and a very good year relative to our blended benchmarks. In fact, at the moment most of our portfolios are beating the performance of the S&P 500 Index for the year to date period, which is entirely unexpected in a year where the S&P is delivering positive returns. However, we are trailing from the market bottom, which is entirely expected. So, “how are we doin?” It depends on your investment time horizon and what benchmark you care to use.