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.
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 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.