Absolute vs. Relative Performance

Absolute performance

Most individual investors judge investing success by asking whether at the end of some standard time period, say, a year, they have more money than they started with or less.  In other words, they judge performance on an absolute standard:  +8% is a good year, -3% is a bad one.

Relative performance

Professional investors normally use a different yardstick.  They, and their customers,  judge their performance by a relative standard.  How has the manager done versus a benchmark index?  How has the investor done in comparison with a universe of his peers?  Looking at performance this way, if the benchmark is the S&P 500 and it’s +10% for the year, then +8% isn’t so hot.

If the client wants a low risk approach and has said, in effect, try to get some outperformance if you can but it’s very important that you not underperform by more than 100 basis points (=1%), then +8% is horrible.  (One might reasonably ask why a client would ever hire an active manager and give him instructions like this, but I’ve seen it done.)  On the other hand, if the client wants a higher risk approach and has hired a manager he thinks will outperform over a market cycle but who will be +/- 400 bp in any given year, then two percentage points under the index isn’t so bad.

Performance vs. peers

Performance vs. peers is a secondary measure that institutional investors use.  Almost always, it’s a weaker criterion than performance vs. the index, especially so in the US.  Here, almost no active manager beats the index.  But one can argue that a manager has at least some skill if he does better than other managers.  There are times, however, when comparison vs. peers serves a very useful function.  For international managers during the Nineties, the “lost decade” for Japan, for example, virtually every manager beat the international EAFE index by underweighting the Japanese market.  So customers began to differentiate performance either by separately analyzing performance vs the index in Japan and in non-Japanese markets or, more commonly (I think) by comparing managers with each other.

Individual investors

Individual investors strike me as wanting the best of both worlds.  They want index-beating performance in the up markets, and also expect to avoid making a loss in the down years.  Hence, the appeal of Bernard Madoff or of hedge funds.  After a good several-year run, the average hedge fund has underperformed the S&P 500 every year from 2003 onward, before completely blowing up in 2008.  We all know the Madoff story.

Gains every year are hard (impossible?) to achieve

Why is absolute return so hard to achieve, apart from holding cash-like instruments like a money market fund or treasury bills (both of which are yielding pretty close to zero at the moment)?  It’s because interest rates change with the business cycle.

Take the case of a 10-year treasury bond.  Suppose you buy one for $1000.  It’s currently yielding about 3%.  So you’ll get a payment of $30 yearly from the treasury and your $1000 back in 2019.  That won’t change, no matter what happens in the economy between now and then.  The 3% yield is more or less determined by the federal funds rate (the overnight lending rate between banks) has been set very close to zero–say, .25%–because the economy is so weak.

Over the next few years, we hope, the economy will get better and the fed funds rate will rise to a more normal 3%.  The yield on a 10-year bond newly issued then will probably be around 6%.  What happens to the price of your bond?  Well, if a yearly payment of $60 plus return of principal at the end of the bond’s life is worth $1000, then our yearly payment of 3% plus return of principal must be worth less.  It’s possible that, in a given year, that the decrease of value of our bond will be greater than the 3% coupon payment we receive.  In other words, we’ll have a loss that year on our investment.

That may not matter so much to us.  We have a guaranteed stream of income and we’ll get all our principal back at the end of ten years.  So our investment objectives are probably all being met.  In fact, if we thought a bout it a little more we might conclude that what we really want is stability of income.    In addition, it may well be that having a temporary loss (short-term volatility) isn’t a particularly important investment objective for most people, even though it is the most common measure of risk used by academics and pension consultants.

Why relative performance?

What makes relative performance, as hard as index outperformance may be to achieve, so popular a way of judging managers?

For one thing, the practical task of management is easier. The question of which stock will likely perform better, AAPL or DELL, is almost entirely about the strengths and weaknesses of the two companies and about the relative valuation of their stocks.  If I’m competing against an index that has DELL in it and I hold AAPL instead, I’ll outperform if AAPL does better, no matter whether they go up or down.  In contrast, the question of whether AAPL will go up or not is also one about the state of the world economies and the direction of currencies and interest rates, among other things.  And in the past year or so, we’ve seen the stock go from about $200 a share down into the $80s, without much change in the underlying company’s results.

It allows managers to specialize.  If a manager runs a health care portfolio or specializes in Pacific Basin stocks, he can presumably develop a depth of knowledge–both about the stocks and about the composition of the index–that will enhance his returns.

Part of the responsibility for portfolio risk shifts back to the client, or at least away from the manager.  In most cases, the client has an advisor–a financial planner, a broker, a pension consultant–who helps make the ultimate decision about where a given manager fits in the client’s overall portfolio.

Another aspect of the last two points is that the manager doesn’t have to coordinate his actions with other portfolio managers, or even understand the risk perameters of the client’s overall holdings.  That’s done by the advisor or the client himself.

This way of operating–multiple managers operating in isolation but coordinated by a third party–got a huge boost from the Employee Retirement Income Security Act (ERISA) of 1974.  By setting more stringent requirements for the professional training and experience of pension managers, ERISA encouraged companies to seek third-party managers for their pension funds.  This gave rise to a bevy of consulting firms to help companies develop asset allocation strategies for their pensions, as well as to help select and monitor third-party investment managers.  The consultants promoted a philosophy of centrally (company + consultant) developed investment plan carried out by a diversified group of highly specialized managers.  As luck would have it, this created a key role, rich in fee income, for the pension consultants themselves.  Companies didn’t mind that much, because they were transferring the risk of underperformance from themselves to the managers and the risk of picking the wrong investment firms to the consultants.  Since managing corporate pensions was an immense growth business for investment companies in the Seventies and the Eighties, the consultant-approved model of highly focused managers became the industry norm.

Individuals and a Hybrid Model

The traditional model for a retiree has had two parts:

–to secure a steady stream of income through a defined benefit pension plan + social security, using an absolute standard for assessing what is good enough; and

–to hedge agains unforseen circumstances, including inflation, by holding equities, whose performance would be judged (if at all) by a relative standard.

This traditional world has been turned upside down in recent years.  But that”s a story for another day–actually it’s the story this blog hopes to tell for some time to come.

Note:  See more recent comments on this topic in my 9/29/10 post.

HSBC rights issue–post mortem

The Financial Times reported today that 97% of the HSBC rights were taken up by investors.  The issue price for the new shares is 254 pence.  The other 3%, the rights that lapsed, became the property of  the underwriters and sub-underwriters.  These rights were exercised by them.  The resulting shares were sold this morning for 448 p. each.  

How did the sub-underwriters make out?  For each share they underwrote, they received a 2% fee, or 2.08p.  But, as I pointed out in my earlier writing about the issue, the fee is not the main source of income for the sub-underwriter.  For the 3% of the shares that the sub-underwriters took possession of, they received a profit of 194p per share, which works out to 5.82p for each share underwritten.

Shaping a Portfolio for 2010 (IIIc.)–Risk Control

To recap from earlier posts:  we’re assuming that you have 85% of your stock exposure in an S&P 500 index fund.  Of the remaining 15%, you intend to put 10% into sector mutual funds (again, index funds, unless you have strong reasons to do otherwise and a commitment to monitor your progress).  The rest goes into individual stocks.

It’s very important to figure out how adding either mutual funds or individual stocks changes the risk composition of your portfolio vs. the S&P.   You want to do this so that you understand the amount of risk that you’re taking on.  But you also want to avoid two kinds of bad outcomes in your equity structure.  You don’t want to end up with what looks like a portfolio but ends up being a gigantic bet on a single idea, as would be the case if you had a bunch of holdings but they were MSFT, CSCO, INTC, a software fund, an internet fund and an IT hardware fund.  On the other hand, you don’t want to end up with bets that cancel one another out.  For example, I once took over a portfolio from a(n unsuccessful) manager who had loaded up on oil and gas stocks, on the idea that energy prices would rise, but also held large amounts of petrochemical stocks, which would only do well if energy prices fell.  So the 20%+ of his portfolio that these two positions represented was just a waste of time.

Mutual funds:  There may be industry groups, like biotech or internet or telecom, that you have very strong conviction in.  If so, you would buy funds in these areas, adding to your health care, technology or telecom weightings.  Let’s assume instead, though, that your strongest conviction is that, as far as the stock market goes, we are past the worst and the next major move is up.  So you want to use your mutual fund 10% to create a general overweight in the (four) most economically sensitive sectors.

From an earlier post, you can see that these sectors are:  technology (18% of the index), industrial (10%), consumer discretionary (9% ) and materials (3%).  Probably the easiest way to deal with materials is through a natural resources fund, which will also have energy (13%) in it.

You may want to keep track of what you’re doing on an Excel spreadsheet.    You will probably go through a number of iterations of the process, both for mutual funds and again after adding individual stocks, until you’re satisfied with the ultimate risk profile you’ve established.  Also, you want a record of your thought process so you can analyze and critique it as results come in.

List the sectors and their weightings on the spreadsheet and reduce all the entries to 85% of the original number.  That’s your index position.  Add 2.5% to  each of the four sectors mentioned above, which will make your weightings add up to 95%, and recalculate the new weightings as percentages.  You should see that you’ve added about 1.5 percentage points to your consumer discretionary weighting, 1.4 to industrials, .8 to natural resources and .6 to technology.

Then consider individual stocks.  Here, the most important consideration is that you understand the company and have reasons to think it will do well, especially with US stocks.  (The US is a stock picker’s market.  It’s nice to have a favorable industry tailwind, but it’s not as crucial as it is elsewhere stock markets. ) As far as your portfolio goes, your individual stock choices may tend either to increase the sector bets you are making through mutual  funds or to reduce or negate them, depending on what industries the stocks fall into.

Assume the stocks you decide to buy are AAPL and TGT (these are high-quality companies but I don’t own either), and you’re going to have 2.5% of your portfolio in each. Add 2.5% to the IT percentage in the 95% column and another 2.5% to consumer discretionary.  This will give you 100%.  Subtract these weightings from the index values to see what your over- and underweights are.

You should have overweights of about 2.3 percentage points for the IT sector, 1.0 for industrials and 3.7 for consumer discretionary.  Natural resources (materials + energy) should be about neutral and the other sectors underweight.

Adding up your overweights gives you 7, which is the same as the underweights.  You can gain outperformance if the overweights work out or if the underweights work out, or both.  If we say an outperforming sector will do 7% better than the index and an underperforming sector will do 7% worse, then you stand to make .49% of your portfolio in performance from each side (7% of the portfolio deviating from the index times 7% in extra return =.49% of the portfolio in performance).  So, in a market that’s not particularly volatile, you can gain (or potentially lose) about 1% of the value of our portfolio from your sector setup.

You have additional stock-specific risk in the equity holdings.  I’ll talk about that in a later post.

You may be tempted to dial the risk level up from what I’ve described.  Until you get more experience and feel more comfortable with this approach, I wouldn’t do so.  It’s relatively easy, psychologically, to dial up the risk level (but not too much) once you’ve been successful.  But it’s very hard to do the reverse.

Shaping a Portfolio for 2010 (IIIb.)–Next Steps

The next thing to think out is what you hope to achieve by changing the composition of your equity holdings from the index.  This should include what you stand to gain if you’re right, what you stand to lose if you’re wrong and any indicators you are going to watch to monitor which way things are going.

Let’s lay out some parameters.  To make the math easy, assume you have $1,000,000 in stocks.  If you’re going to have 85% in the index and actively manage the rest, then you’re working with $150,000.  Of that, let’s say $100,000 will go into mutual funds and $50,000 into individual stocks.

I think a reasonable assumption for a typical twelve-month period would be that the index will gain 8%.  The leading sectors in the market may be up 15% and a good individual stock could be up 20%.  Relative to the index, then, if everything goes right for you, you might expect to gain 7%, or $7,000,  from your active mutual funds and 12%, or $6,000 from your individual stocks.  Your total would be $13,000.

It’s also  reasonable to assume rough symmetry in the markets, so that you have the potential to underperform to the same extent that you might outperform.

This brings us to the first checkpoint:  is it reasonable for you to hold anything other than index funds?  If you can’t afford to lose $13,000 vs. the index return, then you should stick with the index.  If $13,000 isn’t enough for you to bother with–the other limiting case–then again active management is not for you.

The returns you experience can also fall outside the bounds I’ve just set out.  Were they to, the main reason would most likely be the individual stocks you selected.  If this were the beginning of 2005, for example, and you bought $25,000 worth of AAPL and held it for a year, you would have more than doubled your money.  If it were the start of 2008, however, and you bought $25,000 worth of LVS and held it throughout the year, you would have lost 90% of your money.

Let’s look at mutual funds first.  If you turn back to Shaping a Portfolio IIIa, you’ll find a listing of the sectors in the S&P 500, with their approximate weights in that index.  You can alter the sector composition (and thus the risk profile) of what you hold by adding mutual funds or ETFs, in either of two ways:

you can buy sector funds that replicate the index, or

you can select an actively managed fund.

In the first case, you are exposed to the possibility that the sector you pick will perform differently (over or under) from the overall index.  In the second, you have the extra risk that the manager you pick will deliver returns that are different from the sector’s.

For now (and maybe for ever), let’s stick with sector index funds.  How do we go about selecting sectors to invest in? The answer is that we develop a strategy.  We find reasons why a given sector could perform well or badly.  We decide how much conviction we have in those reasons, so that we have a blueprint for what the portfolio should look like.  And we record what we’ve decided so that we can assess how our strategy is working when we do periodic measurements of our performance.

A strategy doesn’t have to be very detailed.  It can be something as simple as, “I think the US stock market is somewhere around the lowest level it will get in this business cycle and the next big move is up.  Therefore, I will overweight ecnomically sensitive sectors (the top of the list in Shaping IIIa) and underweight the defensives (bottom of the list).”  The important thing is to have reasons why you’re likely to be correct and to have something to check those reasons against.

Two minor tricks of the trade:

1.  Your main conviction doesn’t have to be a positive one.  In today’s world one’s strongest belief might well be that US banks are going to have a very tough time over the next few years, so the best thing to do would be to avoid them.  If that’s your only real conviction, then buy everything else in the index except the financials.

2.  You don’t have to have an opinion about everything.  In fact, you’re probably better off having one or two few well thought out ideas, where there’s a reasonable chance you know things other people don’t,  than a bunch of half-baked thoughts that are most likely to be wrong.

Ed Hoculi and Congress

Mr. Hoculi…

Referees are supposed to be invisible. Everyone knows they’re on the field–highly trained, deeply knowledgeable about the rules, watching every play to ensure the game is being played the way it should be. When a referee becomes visible, it’s usually a bad thing.

This happened last football season to an NFL referee, Ed Hoculi. In the waning moments of a game the San Diego Chargers were on the verge of winning, Mr. Hoculi made a clearly incorrect call that handed victory to the Denver Broncos instead. Mr. Hoculi immediately acknowledged his error and expressed his regret. Despite a long career as one of football’s best officials, he has been disciplined by his league. He no longer appears in the most important games, apparently waiting for his invisibility to be restored.

…and Congress

I think investors think about their governments in much the way sports fans think about referees–that officials are intelligent, competent, there to save the day when trouble emerges. That’s why I think both the markets and ordinary citizens were so shocked last year when some Republican congressmen blocked the first bank bailout bill, saying the US would (in some way not clear to me) be better off if credit markets collapsed. Then the plans that Congress did enact kept changing, sometimes retroactively.  Treasury Secretary Paulson, despite his supposed deep knowledge of Wall Street, intensified the crisis by allowing Lehman to fail.

But what seems to have made the most profound negative impact, particularly among foreigners, on the credibility of the US has been the Democrat-led attempt to retroactively rewrite the tax laws to punish a group of (admittedly pretty slimy) AIG traders. To some, the emotional tone of Congress conjures up memories of the McCarthy hearings of a half-century ago. Others point to the apparent unconstitutionality of a punitive tax directed at a specific minority. Still others worry about the apparent lack of thought given to other consequences of the proposed legislation–that US financial institutions might be drained of talented workers, for example, who could avoid a punitive tax by plying their trade for a non-US bank. Probably the most disturbing is the idea that our legislators don’t appear to know very much at all about how the economy works, or even what the issues are. It’s sort of like going to a game and discovering the refs not only have never played the sport, even on an amateur level, but have not made any effort to read the rule book.

The investment point:

There’s an investment point here. I think there are two big imponderables facing the US stock market in the years ahead. The first is how, and for how long, the immense loss of wealth by US financials will have a negative effect on the US economy. The second is what damage the poor performance of our politicians during the financial crisis will do to the prospects for future investment in the US, whether by companies or individuals, US or foreign.

No one, other than possibly the residents of San Diego, have lost faith in Mr. Hoculi. No one has stopped watching football. On the political front, it’s true that in addition to laws, every country has informal rules that stack the deck to some degree in favor of locals. In the US during the Eighties, for example, Japanese automakers adhered to “voluntary” restrictions on imports to the US for fear of punitive legislation if they didn’t. It’s ok for European allies to own US ports but not Middle Eastern ones.  In today’s world, it will be extremely difficult for any Chinese entity to buy US assets. Of course, Coke can’t buy a Chinese juice company, either. France recently barred Pepsi’s bid for Danone, on the idea that the latter’s yogurt technology is a strategic national resource. And in Russia, the rules can change retroactively almost any day.

Yes, the playing field isn’t ever completely level anywhere. But the local ground rules are usually very well understood and factored into any investor’s risk/reward calculations. Until six months ago, the US has been regarded as relatively open and relatively stable. Today, I think Congress has pushed us much farther toward the “unstable” end of the scale than we would care to think. We have to worry about how long this will last–whether, like Mr. Hoculi, Congress will gradually become invisible again or whether it poses an enduring risk to the size of new investment flows.