For more than a generation the investment world has found itself distracted by an obsession with attempting to control for benchmark risk. This has become so prevalent as to infect the vocabulary we use to talk about investments as well as the conceptual framework we use to think about issues such as manager evaluation, risk and portfolio construction. This is wrong. As David Swensen of the Yale Endowment has commented, you will not succeed in active management if you try to control for benchmark risk. It is self defeating as the only way to earn returns commensurate with the risk of owning equities is to deviate from the benchmark. You must also be patient to allow this approach to work.
It’s a sad fact that that most active mangers have underperformed. This has been used as an argument in favour of adopting a passive approach to investment management. However, the reason for underperformance is exactly because many “active” managers are in fact closet-indexing. A study by Cremers & Petajisto in 2006[1] looked at the overlap between the portfolios of US mutual funds and their benchmarks. A small overlap with, or a high deviation from, the benchmark gives a high “active share”. They found that active share has been falling since the mid 1980’s but that there was a strong correlation between active share and long term performance. It was the closet indexers who pulled down the overall average.
Being right in the long run, however, can mean being out of step with the market in the short run. In fact, the more active you are, the more it is likely to happen. A study by Davis Advisors of 160 managers who were top quartile over a ten year period showed for at least one 3 year period 98% were bottom half and 43% were bottom decile. Periodic underperformance is inevitable and is no test of skill. Sack managers for not being active, but not for periods of underperformance.
Volatility is Not Risk
The root cause of this obsession with the benchmark is a misunderstanding of risk. Investment risk relates to the risk inherent in the company whose equity you are buying. This might be production risk, financial risk, competitive risk or some other form of commercial risk. What it does not include is the volatility of the share price. In fact, share price volatility equals opportunity, not risk. The most common sense of all investment principles is “buy low, sell high” – a volatile share price allows you more opportunity to do just that.
The obsession with volatility, and the quantifiable form by which it is measured, tracking error, has also led to an unhelpful deemphasizing of the unquantifiable. This has been variously described by the economist Knight as “uncertainty”, by Keynes as “things we simply don’t know” and possibly even what Donald Rumsfeld meant by “known unknowns”. It may not be easy to consider such things but that does not make it any the less important for successful investing.
Portfolio Construction
Diversification is an alternative to tracking error for the measurement of risk at the portfolio level. This can be quantified by calculating the effective number of assets in an unequally weighted portfolio, which corresponds to the number of assets you would have in an equally weighted portfolio with an equivalent level of diversification.
Diversification has the further benefit of aiding portfolio construction without reference to a benchmark. Returns in a long only portfolio are asymmetrical in that the most you can lose from any one stock is 100% but the most you can make is, in theory, limitless. Therefore portfolios should hold enough stocks to maximize the probability of including big winners (although still few enough to allow a meaningful impact by those individual winners on the overall portfolio). This tends to result in quite diversified portfolios. Given the asymmetry of returns and the diversified portfolio you can also afford to be right less than half the time if you have enough big winners.
Conclusion
- Active management works. The problem is too many “active” managers don’t do what they say they do.
- Volatility does not represent risk – it represents opportunity.
- Asymmetry of equity returns argues for a diversified portfolio which maximizes the probability of including big winners.
[1] “How Active is Your Fund Manager? A New Measure That Predicts Performance”, Cremers & Petajisto 2006, Oxford University Press.
Gerald Smith is deputy chief investment officer for Baillie Gifford, Scotland.