a professional portfolio manager performance check

I subscribe to the S&P Indexology blog.  Like most S&P communications efforts, I find this blog interesting, useful and reliable.

Anyway, two days ago Indexology published a check on the performance of equity managers who offer products to US customers.

In one respect, the findings were unsurprising.  For managers with US stock portfolio mandates, well over half underperformed their benchmarks over the one-year period ending in June.  Over five years, more than three-quarters failed to match or exceed the return of their index.

This is business as usual.  Why this is so isn’t 100% clear to me.

One of my mentors used to say that ” the pain of underperformance lasts long after the glow of outperformance has faded.”   I think that’s right.  In other words, clients will punish a PM severely for underperformance, but reward him/her by a much smaller amount for outperformance.  In a world where risks and rewards aren’t symmetrical, it’s probably better not to take the buck-the-crowd positions necessary to outperform.  Instead, it’s better to accept mild underperformance, keep close to the pack of rival managers and spend a lot of time marketing your like-me/trust-me attributes.

(To be clear, this isn’t a strategy I wholeheartedly embraced.  I generally achieved significant outperformance in up markets, endeavored not to lose my shirt in down markets.  My long-term US results were a lot better than the index, but at the cost of short-term volatility that was greater than the market’s.  Pension consultants, heavily reliant on academic theories of finance, tended to demand a smoother ride, even if that meant consistently less money in the pockets of their clients.  Yes, a constant problem for me.  But it illustrates the systematic pressure put on managers to conform, to look like everyone else.)

 

The surprising news in the blog post comes in international markets.   Generally speaking, the markets overseas are simpler in structure, information flows much more slowly than in the US, and PMs tend to be ill-trained and poorly paid.  Rather than being the culmination of a long a successful career, being a PM abroad is often only an early stepstone to something better.  So pencil in outperformance.

On a one-year view, however, Indexology reports that the vast majority of managers of global, international and emerging markets portfolios all underperformed their benchmarks.  This is the first time this has happened since S&P has been checking!!

I don’t watch this arena closely enough to have a worthwhile opinion on how this happened.  The fact of underperformance itself is surprising–the fact that more than 75% of managers of international funds underperformed is stunning.  My guess is that no one saw the deceleration of Continential European economies coming.

For anyone with international equity exposure, which is probably just about everyone, current manager performance is well worth monitoring closely.

 

why aren’t global portfolios more popular?

Last week the Wall Street Journal ran an article, written by a London-based reporter, questioning why Americans divide their equity portfolios into domestic and international, rather than operating the way the rest of the world works by using global equity funds.

what they are

Let’s get a definitional point out of the way.

Generally speaking, a global fund invests in both the domestic stock market and in foreign stock markets.  An international fund invests just in foreign markets.

In the US, the terms were used interchangeably until the mid-1980s.  That’s when the SEC began to provide standard definitions for the names used by mutual funds so that investors would be able to tell more easily what the fund did.  At that time, the agency said a fund that called itself “global” had to invest in several foreign stock markets and to have a minimum of 25% of its assets invested outside the US; an “international” fund had to have at least 50% of its assets outside the US.

As a practical matter, international funds normally have virtually all their assets invested in non-US markets.  Global funds vary from being US-oriented portfolios with a few bells and whistles, to funds with a hefty majority of their assets outside the US most of the time.  Some stay with relatively rigid country or regional allocations; others take an individual stock or sector approach and let the country weightings fall where they may.

One additional complication:  as domestic-oriented American portfolio management companies caught on to the power of foreign markets in the 1990s, many changed their prospectuses to allow their domestic funds to make large allocations to foreign market.  30% of the assets is a typical number.  In practice, however, most US-oriented funds have minimal foreign holdings.

a US distinction

Except for the heyday of Japan in the late 1980s, the US stock market has been the world’s dominant bourse since World War II, representing at least half of the total value of publicly traded companies worldwide almost all of the time. So global (all around the world) and international (foreign only) are clearly different.

For most other countries–take Sweden as an example–that’s not the case.  Sweden’s domestic stock market is about 1% of the worldwide total.  So, for its citizens, global and international are basically the same thing.

Also, other countries are much more trade-oriented than the US.  They have plenty of foreign partners right on their doorstep, and not an ocean away.  So every day the rest of the world announces its presence loudly and clearly. Their life experience pushes them to be global investors.

advantages of global

To my mind, global has three plusses:

–information flow  This is the life blood of any equity investment operation.  Third-party information sources (read: sell side analysts) tend to be much  more parochial than they realize and, general speaking, to be apologists for their home-country companies.  Taking a global perspective forces a manager to gather and analyze data from around the world.  This turns out to be a huge advantage.

diversification  A global portfolio spreads its risks all over the world, not in just a small subset.  Imagine that you wanted to get exposure to smartphones, but you can’t buy Apple.  You’re a Europe fund and your only choice is Nokia.

–learning the local rules  Local investor preferences can strongly influence which stocks are winners and which are losers.  In my experience, one-country managers tend to be oblivious to this and to assume, incorrectly, that their own customs transfer seamlessly around the world.  It’s sort of like thinking you can use your local money in every foreign restaurant or store, or that all TV programs in a foreign country will somehow be in your language.

risks

–Running a global portfolio requires more skill than a one-country portfolio.  So you’re more dependent on the expertise of the management company.

–It’s harder to look at a list of fund holdings and figure out whether the strategy makes sense.

–You have more of your eggs in one basket.

why global isn’t more popular

I made an initial sales call in the mid-1990s on a major US corporation that was a  long-time pension fund customer of my firm.  My performance numbers, over nearly a decade, were better than those of any equity manager the customer had hired.  And the executive who made the manager selection decisions was deeply dissatisfied with most, if not all, of his international managers.  Sounds promising, you might think.

However, the executive opened the meeting by saying he was talking to me as a courtesy to our sales representative, but that there was absolutely zero chance that he would ever hire me.  Why?  He didn’t believe that anyone could possibly be successful making global equity investment decisions.

I was curious and I realized all I could get from this meeting was information.  So I asked the client how he could think this, since a large part of his own job was making global decisions on asset allocation.  His reply was very instructive.

He said, in effect, that his power and status in his company stemmed from the fact that he made the global asset allocation decisions, and that he interacted with the series of  highly paid pension consulting firms that gave him advice on what to do.  If he began hiring people like me, his position in his company–and, by implication, that of the consultants his firm had hired–could potentially be diminished.  While my services might benefit corporate retirees, they were a threat to his power that he couldn’t tolerate.

The WSJ article quotes an investment advisor who says basically the same thing.  He maintains his control of his client by ensuring that the investment process is complex and that he has a central role in the decision-making.

Global offers the possibility of better performance and lower fees.  The status quo understands, and fears, this.