Practical analysis for investment professionals
28 July 2015

Alpha Wounds: Benchmark Tail Wags the Portfolio Management Dog

Active management is under siege from many corners, including passive investment advocates, robo-advisers, academics, and individual investors. The narrative, of course, is that active managers add no alpha after fees. Is active management dead? Hardly. But active management is certainly wounded. And many of these alpha wounds are self-inflicted.

This and other forthcoming articles will seek to identify some of these wounds and propose some possible solutions for practitioners of active management.

Benchmark Tail Wags the Portfolio Management Dog

Chief among the alpha wounds is that the benchmark tail wags the portfolio management dog. What I mean is that benchmarks were supposed to be the foundation for understanding a portfolio manager’s performance after the fact. Instead the investment industry evolved so that benchmarks are now the navigational compass for investment managers before the fact.

How else do you explain a common conversation overheard in our industry that goes something like:

Pension Fund: “We need a new large-cap core manager. Our old one has too much tracking error relative to bench.”

So how did we arrive at benchmark idolatry?

A Brief History of the Benchmark

Profitable investment management firms all have one thing in common: assets under management (AUM) scale. There are two ways to grow an asset management firm: one short-term and easy, and one long-term and difficult. They are, respectively, successful marketing and successful investing.

In the beginning of an asset management firm’s life cycle, AUM is very difficult to acquire. Without quality returns there is not much to market to prospective investors. Consequently, in the beginning, firms — often founded by quality investment managers — focus on generating outsized returns relative to their competition.

But then what happens? Inevitably the firm begins to think to itself, “With these returns in hand, we can now gather assets by telling the world our good news story. Scale is now possible. So, too, is that lustrous paycheck we all work so hard to earn.” Enter those adjuncts to the business that aid our growth through marketing. Exit growing AUM by earning the returns.

Unless an investment manager is careful at this stage, the focus of the successful investment management firm shifts to pleasing adjuncts to the investment management business — private wealth managers, registered representatives, and consultants among them – rather than its clients. But initially what everyone wanted from an investment manager’s performance was similar:

  • A strategy that had the possibility of achieving clients’ financial objectives.
  • A strategy in which returns exceeded the risks in adhering to the strategy.
  • Ideally, risk-adjusted returns that exceeded those of an investment manager’s competitors.

With these three simple bullet points met, clients and the adjuncts were typically happy.

Necessarily though investment adjuncts wanted to identify quality managers from among the vast sea of such beasts. “How do we know that you are as good as you claim in your marketing literature?” “How do we know that you are not taking crazy risks to achieve your results?” “How do we know that you actually have a strategy, and that you are not just a trend follower?” And so on. The questions were many, and they are noble. Fortunately — and I sincerely mean that — benchmarks were invented to help address some of these questions and, most importantly, to help our end clients.

Then whole careers became about refining the process of manager selection beyond simple benchmarking. Philosophical concepts were developed and coupled with hard math to birth new tools. Ultimately what happened is that now if a manager wants to raise AUM through marketing, the price is to clear the preferred mathematical hurdles of the adjuncts.

Particularly pernicious, and especially germane to the current discussion, are the concepts of “style box,” “style drift,” and “tracking error.” If an active manager statistically violates any of these three important concepts, then they likely lose the endorsement of, for example, the consultant who sold the fund to an institutional client. There goes a large chunk of AUM, a measurable amount of operating leverage, and that lustrous annual bonus. Ouch!

The Shackles of the Style Box

The style box was invented because many investment strategies were similar and thus suggested a natural point of comparison. This allowed clients and their representatives to compare active managers to one another, and it also held these managers accountable to their stated strategies. All of this is the work of the angels.

Unfortunately, along the way managers who refused to declare a style because they believed their job was to make money regardless of market and economic conditions did not have access to the rich AUM mine available to those declaring a style box. So most stopped protesting and instead allowed themselves to be chained to a style box.

Also, style boxes became a way of limiting the opportunities available to managers. If a manager is labeled as mid-cap core, then the opportunity set must be the same and thus be smaller. So if you are an active manager with active management skills, you have agreed to be handcuffed in your ability to apply those skills.

The Schizophrenia of Style Drift

If active managers actively search for opportunities to apply their skills to take advantage of the shifting vagaries of asset prices, they now receive the investment industry equivalent of a schizophrenia diagnosis. This comes courtesy of the concept of “style drift.” Style drift was invented to identify managers who, having agreed to be shackled to a style box, had the audacity to attempt to shed those bonds.

The Error of Tracking Error

Last among the benchmark-related concepts that unintentionally make active managers inactive is tracking error. Tracking error compares the actual performance of an investment manager to the benchmark and comes loaded with a qualitative judgment. Specifically, you must beat the style box benchmark while limiting your universe of possible investments to keep style drift low. But should you succeed in this endeavor, then you cannot do so by too much. Else, you have tracking error.

We Active Managers Did It to Ourselves

The preceding may have convinced you that I blame academics, consultants, private wealth managers, and other investment industry adjuncts for the current sad state of active management. But I do not.

Active managers: We have done it to ourselves! In short, we allowed static concepts, such as benchmarks, style boxes, style drift, and tracking error, to contravene our mandate to be active managers. I actually like each of these concepts (and worked for a pension consultant early in my career) and believe they are useful . . . in moderation. But there are remedies to this madness that can restore moderation. Here are some:


  1. Earn AUM through performance, not marketing. A majority of your time should be spent on research, not giving presentations to third parties.
  2. Run your firm leanly. If AUM walks out the door because you begin managing money for end clients and not for the expectations of a third party, then you still have scale enough to endure. Remember: good performance news eventually reaches client ears . . . especially in the era of social media.
  3. Remember that benchmark is a noun, not a verb — namely, “A standard or point of reference against which things may be compared or assessed,” according to Oxford Dictionaries. Where in this definition does it say that you should navigate to the benchmark? Your job is to navigate away from, and better than, the benchmark.
  4. Talk to your clients and develop a relationship with them so they know who you are and what your investment philosophy is. Then they may develop expectations in alignment with yours.
  5. Be aware of the potentially Faustian bargain entered into when you agree to be measured by third parties in exchange for possible AUM favor.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor and the CEO of Active Investment Management (AIM) Consulting. Voss also sub-contracts for the well known firm, Focus Consulting Group. Previously, he was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. Voss holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: [email protected]

30 thoughts on “Alpha Wounds: Benchmark Tail Wags the Portfolio Management Dog”

  1. Sean Seah says:

    hi Jason, thanks for your succinct analysis. This issue is probably one of the most overlook fundamental issues in asset management industry. Fund managers like us in Malaysia are facing this predicament.

    1. Hello Sean,

      Thank you for chiming in on this issue. When I was a fund manager – now almost ten years ago – this was already a difficult issue to manage for our firm. Unfortunately, the issues, to my mind, have only accelerated.

      Again, thanks!


  2. Ilir Shkurti says:

    I believe the issue is one of managing expectations. If a manager is hired to “be” the market or play a specific role (such as the “core” or a “satellite”) within a portfolio, then it is fair to impose tracking error, information ratio and other relative comparisons, in my opinion. On the other hand, if the starting point is a shared expectation of what will make both parties “happy,” there is still room for quantitative performance attribution but the relationship is far sturdier to the vagaries of benchmarking.

    Active management has become a “loser’s game,” in the words of the illustrious former head of the CFA Institute, Charlie Ellis. This is because there is far more uniformity in the participants’ skills and resources, that “winners” are established more by avoiding mistakes (losing less) rather than going for the winning points.

    All managers can’t all be above-average – this is by definition. Yet, all managers have the potential to serve a client based on what they bring to the table consistently. Surviving cycles of performance reviews will take faith from both parties and on both parties, so that the “flavor of the year” game can be avoided. This comes back to properly setting and managing expectations.

    1. Hello Ilir,

      First, thank you for taking the time to share your thoughts. I really appreciate your providing an in-depth response to the article.

      Next, I think you are correct that managing expectations between client and manager is a critical issue. This is the critical piece of advice to have in place before negotiating for assets with a client. I think in the current era of investing most money managers find themselves having already painted themselves into a corner. One problem is that most money managers (in terms of numbers of money managers, not in terms of as measured by total AUM) are at least one step removed from the client. Also, as I described in my piece many believe that it is impossible to turn their nose up at the measures I describe, and to simultaneously satisfy the consultants that evaluate them with these measures. Lose the measures, then lose the consultant, then lose the client, then lose the assets, then lose your scale. Few are willing to risk such a conversation.

      I will share with you a comment I received from a CIO about this person’s firm and maintain their anonymity, “As expected, I do not find the [alpha-generating] material useful in my career currently. Investment decision-making is so constrained. The amount of time commitment necessary is difficult to justify for what is essentially ‘two worlds colliding.’ This program coaches you to earn alpha by thinking out of the box, whereas advisors, fund manufacturers, regulators and your clients require you to stay in the box.”

      Sadly, in my many conversations with asset managers their choices have resulted in little ability to manage expectations with clients.

      Please keep those comments coming!

      Yours, in service,


      1. Ilir Shkurti says:

        Thanks, Jason! Always appreciate your thorough follow-up.

        You have nailed it in regards to the middleman. In choosing to cater to the consultant, the manager trades the direct relationship for access to larger asset pools.

        I had a comment made to me by a manager of managers to the effect: “It takes three years [for the manager] to get hired with us, one and a half to be fired.” It stuck me as shortsighted, particularly given the source, which I consider to be respectful. If you have committed to a manager for the right reasons, there is no reason to fire someone for failing to produce superior results by following the right strategy (what they state they are competent in). By the same token, I would actually be more in favor of firing someone for producing a superior return but deviating from their stated core competency, because it is arguably random and not expected to persevere.

        Another issue I have with the sacking of managers is that a high water mark is the client’s asset (Leon Cooperman is fond of saying this). By firing a manager after a bad period, a consultant or manager of managers may be depriving clients of the ensuing recovery, during which the manager is essentially managing money for free (without incentive fee).

        We could go on and on on this fascinating topic, but in the end we come to your conclusion: for managers to mind their investment and not their marketing. The AUM will follow.

  3. Ron Surz says:

    Right on Jason.

    I hope your thoughts reach investors. Nothing will change without investor demand for better advice. Please see

    1. Hello Ron,

      Thank you for your comment. I can certify to the audience that Ron’s work is very, very interesting and has the ability to change the industry.

      Yours, in service,


      1. Ron Surz says:

        Thanks Jason

  4. A clear, concise and accurate representation. Your suggestions are also clear. But it is not so simple and firms need practical guidance. There is a balance that is in everyone’s best interest between the profession and the business

    1. Hello,

      Thank you for your suggestion of the necessity of practical guidance. This is part one of a ten part series. There will be additional Alpha Wounds discussed as well as remedies. My intention is to host an extended discussion on active management. Both in criticism, and in defense. And most of all my intention is to host discussions in the comments section to gather intelligence, and to be able to access the vast storehouse of knowledge out there.

      Yours, in service,


  5. Ahmed says:

    Active managers did it to themselves. That much is clear. I would beg to differ, though, about what really brought about all the damage.
    You say it’s because they let academic concept contravene the mandate. I say it’s because of prevalent poor performance.
    It seems most of the times active managers deviate from benchmarks they hurt returns. People came to idolize benchmarks because deviating from them is mostly a bad idea.
    Think about it. Active managers could de-emphasize some concepts and unshackle themselves as you suggest but then returns might turn out inferior all the same.
    I think the real problem is talent. The industry needs capable calibers that can deliver better performance than the horrible 4 in 5 fail ratio. Hence I agree with the first point on your list of remedies. ‘Earn AUM through performance, not marketing.’ This really is first and foremost.
    Thank you.

    1. Hello Ahmed,

      Thank you for sharing your thoughts. This is part one of a ten part series. I think you will be surprised by some of the other Alpha Wounds that I identify in the series. Expect me to take head on the 4 in 5 fail ratio with that most inescapable of things: data.

      Yours, in service,


  6. Adam Wright says:

    Hi Jason,

    Thanks for this write-up. I look forward to the others in the series.

    I find the comments made by Thomas Howard of AthenaInvest to be accurate as well. His hypothesis is that a lot of under performance is due to firm structure. In other words, along with AUM growth, you have committee investing, over diversification, low insider ownership, bureaucracy, “risk management”, etc. I am being overly simple in conveying his points of view, so if you have not seen his material, I suggest taking a look.

    I think that consultants, advisors, investors, whoever get past simple performance attribution analysis and focus more closely on firm structure, investment process and investment philosophy the future winners become much more clear. Unfortunately, finding good investment managers for the long-term (much like equity selection) takes a lot more effort and qualitative thought than running regression analyses… it also requires patience. What too many of us in the industry suffer from is what Buffett coined as the institutional imperative.

    Keep up the interesting writing!

    1. Hello Adam,

      Yes, Tom and I have talked at length about the state of active management. [You may enjoy the interviews I did with him on Enterprising Investor, I believe three years ago. Just search on “Behavioral Portfolio Management” on our site.]

      Firm structure may be [hint] one of the things in this series [shhhh!], among others.

      Thank you for taking the time to share your thoughts so candidly.

      Yours, in service,


  7. tyc says:

    I want to blame on academic – junk financial literature. Anyone could create an analysis using a set of specific data to show how their models work (but rarely why it doesn’t work). In addition, once advisors noticed a trend, they simply throw the idea into the presentation and hope investors would just buy into them.

    I believe, a firm claiming compliance with GIPS guidance and showing GIPS performance presentation alone isn’t enough. I do hope you’ll have a discussion about performance presentation that would help better educate investors and provide more usefully information then what is currently available on the web.

    1. Hi,

      Thank you for your comment. You may be interested in CFA Institute’s work on improving performance presentation, Principles for Investment Reporting. We agree with you that performance presentation should be better. Here is the landing page for this product: If you want to go directly to the report here is its link:

      Yours, in service,


  8. tyc says:

    This isn’t what I meant by performance presentation. In this blog, so far you mentioned these things: benchmark, style box, style drift, tracking error. We assumed readers understand what each of these analyses are used for and how each of the analysis help explain certain part of the investments.

    What seems to be useful for active managers might not necessary be informative to investors / clients. How do we know for certain that investors / clients really understand what these analyses are mean for? Is it just someone nodding their heads an indication of their understanding?

    I think a question which hasn’t been touch on is if we are correctly providing information that is useful to the final users (whomever they are).

    1. Hello again,

      Thank you for adding to the conversation. I am not certain whether or not you read the entirety of the Principles for Investment Reporting for which I provided a link, but it argues exactly for what you argue, too. Namely, that investment reporting must be in alignment with, not only a client’s investment objectives, but with a client’s understanding of those investments. Further, the PIR argues that the same financial information should be tailored precisely for the audience. This means that an investment manager and her client could receive two different reports based on the same data, uniquely tailored to the needs of both. If an investment consultant wants Sharpe and Treynor ratios, style box, style drift, tracking error, and so forth they may have those measures. But if the client doesn’t care then they should not receive that information. The unifying factors for all reports are GIPS and the degree to which client goals are achieved. The goal of the PIR is to harmonize performance results with client understanding.

      Yours, in service,


  9. Jay Weinstein says:

    Thanks for the excellent piece– I was about to encourage you to elaborate much further on the “benchmark” problem when I saw this is only part one of ten!

    One thing I would suggest taking on– MANY of the benchmarks themselves are Frankenstein’s creations and utterly meaningless. Especially the HFRI and HFRX ones and any “benchmark” purporting to represent difficult asset classes. For example, does anyone really believe the Russell Microcap Index is a useful tool? I managed microcap money for 15 years, and I tell you the index is pointless and managing to it is silly.

    After all, the best is the S&P 500 and even that benchmark has construction issues.

    Keep up the great work, I look forward to the next nine pieces!

    1. Hi Jay,

      Wow, thank you for your kind words…they are truly appreciated. Also, I love your characterization of some indices as Frankstein’s creations. I couldn’t agree more.

      Regarding the other 9 pieces, alas, I was not planning on returning to benchmarks. However, once I have delivered the other 9 pieces I may return to the subject.

      Yours, in service,


      1. Jay Weinstein says:

        As you noted, both investment managers and wealth managers [who hire the investment managers] have brought this problem on themselves by TRAINING their clients to focus on poorly designed or irrelevant benchmarks. The creation of an infinite number of benchmarks, regardless of utility or statistical validity, is a classic example of the tail wagging the dog.

        The truth is, any asset class that cannot be reasonably indexed should be considered as an absolute return vehicle. The active management fee is just the price of admission, just like DisneyWorld! 🙂

        Back in the day, I would simply compare myself to the S&P 500 as essentially that’s the cheapest “monkey throwing darts” benchmark that everyone has access to. If I couldn’t do better after my fees, regardless of what my portfolio had in it, then I didn’t deserve to have a business.

        You write with an excellent voice, I am casting my vote that you pursue this topic further!

        Best regards…

        1. Hi Jay,

          Your commentary rings true to me. Thanks for sharing your thoughts. Thanks, too, for the compliment about the writer’s voice.

          Yours, in service,


  10. Jason,

    I think you nailed it in this first post. We have this same conversation with our clients all the time. I look forward to reading the rest of this series.

    I did have a question about the following statement:

    “How do we know that you actually have a strategy, and that you are not just a trend follower?”

    When you say “trend following” do you mean performance chasing or do you mean all trend following strategies including CTAs and managed futures? If the latter, how would you explain the “alpha” generated from the momentum factor in the Fama/French research?


    1. Hi Elliot,

      Thanks for the praise and for the question. Regarding my statement…I was referring to the closet indexer. The money manager that looks at the portfolio holdings and thinks that it is a radical alpha generator to overweight by less than 100 basis points a particular sector because of a macroview. Or the money manager that looks at the portfolio holdings twice yearly of the top performers’ in his/her category and buys the same stuff so as to minimize the amount by which they trail. And so on. Lots of examples.

      The results of our business our objectively measured, not subjectively. In short, “Show me the money!” of a strategy.

      Hope that helps to clarify!


  11. Gerry Heffernan says:


    I greatly appreciated your piece. (As well as many of the comments) I agree with your assertion that benchmarks have created a problem. As an institutional manager I was often asked what benchmark I should be judged against. In most cases I told the client (or consultant) that that was their decision. That if they were in agreement with my investment philosophy and process (two very different things that I’m interested to see if your future writings will touch on) and choose me to run their money then I will do my very best to maximize their return and then we can compare it to whatever benchmark they see fit to better understand the returns that were produced. The benchmark should be used to review performance, not as a starting point for building a portfolio.

    As far as the consultant (the middleman) being the problem I would offer the argument that it is the portfolio managers responsibility to establish a strong relationship with the end client. This is not to say that one should try and squeeze out the consultant. Rather, if a strong relationship is forged between manager and client where the client has chosen the manager for philosophy and process, (not statistical tables in a pitch book) then the performance review meeting will have much more of a partnership tone as opposed to a judgement panel feel. In my experience this is a preferable situation for the consultant as they are part of the partnership also, and not spending their time worried about having to defend their previous advice. (It also had the very positive effect of future positive recommendations from that consultant) Unfortunately, I believe, that too many managers view the client as judge and jury as opposed to a partnership with the common goal of investment returns.

    I look forward to your future writings


    1. Hello Gerry,

      Thank you for your comments about the consulting community. But even greater thanks for your emphasis on partnerships in service of clients. I believe these are important words, and thank you for expressing them.

      Yours, in service,


  12. Savio Cardozo says:

    Hello Jason
    In your usual inimitable style you have tackled not just the boxed-in manager but also an entire industry whose livelihood depends on keeping that manager boxed-in.
    Like many things in life, as you elegantly point out, you either play the game, or stay on the sidelines.
    Technology may yet undo some of these shackles but it will be a battle hard fought with a lot of lucrative year-end bonus cheques at stake for the investment consulting industry.
    To your last point, my all time favourite poem has to be the Tragic End of Dr. Faustus – what’s a soul compared to paycheques worth several million – a small price to pay.
    Kind regards and a pleasant weekend

    1. Hello Savio,

      Wow, that is such high praise! I agree with you; the implications for the industry would be enormous. Frankly, I am not sure there is any appetite to reform the industry when margins remain north of 25% for most asset management firms. But perhaps if robo-advisers start to harvest the fat in these margins there will then be a desire by the industry to refocus on the client, and on consistent returns, and across all of the products. As opposed to focusing on entities most clients would be hard pressed to explain: the “wire houses.”

      Yours, in service,


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