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:
- Earn AUM through performance, not marketing. A majority of your time should be spent on research, not giving presentations to third parties.
- 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.
- 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.
- 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.
- 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.
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