Category Archives: Portfolio management

Active Share (ii)

March 11, 2016 By in Active Share, Uncategorized Tags: , , , , 1 Comment

As I wrote yesterday, Active Share (AS) is a way to measure the portion of a portfolio that deviates from its benchmark index.  It’s arrived at by adding up all a portfolio’s underweights and overweights, dividing by two and expressing the result as a percentage of assets.  AS can range from 0%, which means the portfolio exactly replicates its benchmark index (i.e., is an index fund), to 100%, meaning the portfolio holds nothing that’s in its benchmark.

what’s good about AS

I’ve always used it as a measure of the riskiness of my portfolio.

If I had four potential outperforming stocks that I thought would carry my portfolio for the current year or more, and the same number of underweights that I had similar conviction in

and if I established, say, a 1.5% difference from the index with each of the eight positions,

and if I thought that my good stocks could outperform the index by 20%, and the bad ones underperform by the same amount,

then I could earn outperformance of 20 percentage points on the 12% of the portfolio that differed from the benchmark.  That’s the same as outperformance of 2.4% for the portfolio as a whole, assuming that everything went according to plan.  (That rarely happens, of course.  Things are either a lot better–or a lot worse.)

+/- symmetry

If we assume the world is symmetrical and that I would lose 20% on any position that went against me (this is a wildly arbitrary assumption), then the worst that could happen (I’m shuddering as I type this) is that the portfolio would underperform by 2.4%.

performance vs. expectations

Okay, I now know something about the risk character of my portfolio.  As a money manager, I also have to ask how this corresponds with the needs and expectations of my clients.

During the mid-1980s, I worked for a couple of years for TIAA, managing money in Pacific Basin stock markets.  In the international area, our performance bonuses maxed out with outperformance of 1% above our benchmarks.  We would receive a small payment for keeping pace with the benchmark.  Even that disappeared entirely, however, if yearly performance fell more than 0.25% below the index.

This is an example, in my mind, of severe risk aversion.  The bonus guidelines told me:  nice if you can get some outperformance, but never, ever, fall below the index.  Arguably, this is closet indexing.

In contrast, I subsequently worked at a firm that for a (mercifully, short) time had a compensation schedule that set the risk bar at +/- 60o basis points vs. the benchmark.  To my mind, this encouraged managers to take crazy high,  risk-the-franchise levels of risk.  More below.

what’s bad about AS

summarizing the good

AS gives a vocabulary for discussing how much a portfolio deviates from its index.  It implictly introduces the idea that portfolio risk consists in such deviation, which I think is correct.

We can also say that there’s something wrong with a $10 billion fund that collects $100 million in management fees yearly for active management, while maintaining an AS that’s at or close to 0.

the bad

On the other hand, there’s a temptation to think that because an AS of 0 for an active manager is bad, that, while an AS of 10% might be good, one of 50% must be even better.

I think that’s wrong, in two ways:

–to get an AS above, say, 30%, a manager has to have deep knowledge and conviction about at least 15 or 20 things.  (One could, in theory, get to that level by making one gigantic stock bet, but regulations and contracts most likely rule out that option.)  I know I could never have been the smart money on so many topics.  I’ve never encountered anyone who could.

Better to be a yard wide and a mile deep than the opposite.

In other words, at some point, I would think, high AS becomes a warning sign that a manager has lost control of his portfolio.  That’s not a positive.

–if an AS of 2% is a Fourth of July sparkler, an AS of 30% is a ton of nitroglycerine.  If all the bets go wrong, the result will be a loss of, say, 12% vs. the index in a year.  No matter what they say up front, this is not what clients expect.  They’ll leave in droves.

 

Active Share, a way of looking at portfolio management (i)

March 10, 2016 By in Active Share, Uncategorized Tags: , , , , 1 Comment

I’ve been reading lately that Europe is in the midst of a regulatory hunt for money managers who profess to be active managers and are charging high fees for this service, while doing nothing of the sort.  Rather, they are “closet” indexers–meaning that their portfolios look, for all intents and purposes, like their benchmark indices.

I can understand the horror EUers must feel at the wealth devastation wrought by European active fund managers, whose performance, both from my experience and the published figures I’ve seen, I regard as far weaker than their US counterparts’ (who admittedly don’t cover themselves in glory).  Being charged high fees for poor outcomes must sting.  On the other hand, the self-aware EU manager must realize that an index fund is the best product he’s capable of producing for his client.  So in a funny sense the closet indexers are doing their clients a favor–except for the fee part.

But that’s not what I want to write about.

Active Share

The tool regulators are using to detect closet indexing is called Active Share (AS).

It’s something I began using to control the risk in my portfolios in the 1980s, while working at TIAA.  The advent of more powerful computers spawned its widespread use in the industry through performance attribution software during the following decade.  But it only earned its capital letters when two Yale academics published an article (“How Active is Your Fund Manager?  A New Concept That Predicts Performance”) about the concept in 2009.

The idea is straightforward.  Find all the positions where the portfolio holds more than the index weighting and total all the “extra” money in those positions (if the manager holds something not in the index, the entire position counts as extra).  Do the analogous thing with positions where the portfolio holds less than the index weighting.  Take the absolute value of both sums, add them together and divide by two.  Calculate the result as a percentage of the total portfolio value.  The result is the portfolio’s AS.

An example:

The index has four stocks, A, B, C and D.  Each has the same 25% weight.

Each portfolio manager has $100 to manage.

Portfolio manager X puts $25 into each stock.  He has an AS of 0.  He’s an index fund.

PM Y puts $26 each into A and B, and $24 each into C and D.  His overweights total $2; the absolute value (minus signs turned into pluses) of his underweights is $2.  His AS is 2%.  He’s a closet indexer.

PM Z puts $30 into A $40 into B, $20 into C and $10 into D.  His overweights total $20;  the absolute value of his underweights is $20.  His AS is 20%.  He’s clearly an active manager.  In the real world of asset management, he’d be regarded as very aggressive.

The Yale researchers conclude that high ASs are a good thing.

More tomorrow.

 

 

Millennials as socially aware investors

January 28, 2016 By in Socially Responsible Investing (SRI), Uncategorized Tags: , , , 1 Comment

I’ve been at least peripherally conscious of the Socially Responsible Investing (SRI) segment of the investment management business for a very long time.  The criteria for a company or security being “socially responsible” have primarily been negative–typically no “sin” stocks, namely, tobacco, alcohol, gambling or weapons.  Maybe no heavily polluting industries, as well.

It’s also been a niche business, with high costs and poor performance results.  I don’t get the results part.  I don’t understand why any portfolio manager would hold tobacco stocks, thereby lowering the cost of capital for a terrible business and enabling in the harm it causes.  Polluters, who will inevitably be caught, fined and disgraced, are a poor bet, too.  In my experience few PMs in the US hold these sorts of stocks (how the ones who do justify this remains a mystery to me), although lots in Europe do.  I have less trouble with the other three industry groups, but all are relatively small parts of the index.  Holding Faceboook, Google or Netflix would more than offset any loss of performance avoiding the sin stocks would cause.  So I’ve never understood why SRI investing results haven’t been better.  Could  SRI investors want underpeformance to validate their virtue?

According to the Institutional Investor, however, the SRI backwater is undergoing a transformation.  That’s because Millennials are showing themselves to be genuinely socially aware investors.  Yes, there are industries where they don’t want to put their money.  But they also appear to be much more knowledgeable about publicly traded companies than older investors (the Internet?  PSI?).   And they have a much greater desire to own companies that aim to solve social or environmental problems, rather than simply avoiding doing harm.

As I mentioned above, most thinking PMs are socially aware in their stock selection anyway.  It’s the right thing to do  …and it makes good business sense.  Just don’t tell a potential client, or he’ll conjure up the image of a performance-indifferent hippie, despite your conservative suit and tie.

My guess is the the first evidence of SRI-aware Millennials will not be in a flowering of SRI funds and ETFs.  Rather, we’ll see it in incrementally better performance of companies with highly ethical managements and in industries that target social good.  If SRI funds could post competitive investment performance, they may participate, too.

 

GoPro (GPRO) and the mood of the market

January 14, 2016 By in Portfolio management, Shaping a Portfolio for 2016, Uncategorized Tags: , , , 1 Comment

a concept stock

I’ve watched GPRO from the sidelines since it went public in mid-2014 at $24 a share.  It’s the maker of the HERO line of wearable cameras for self-recording sports action.

The stock peaked at close to $100 a share in October 2014, amid discussion that the real value of GPRO was not in the devices themselves but in the potential for creating a YouTube-like video sharing network that could, Wall Street proponents thought (and wrote), add billions of dollars to the company’s market cap.

a long fall

The stock closed regular trading yesterday at $14.61 (!), up a penny from the day before.  According to Reuters, of the 20 analysts that cover the company ten are still bullish and eight neutral.

last night’s bad news

After the close, GPRO announced that the seasonally most important fourth quarter sales would fall 14% below the company’s prior guidance.  As I’m writing this trading in New York has just begun and GPRO shares are down about 19% at around $11.70 and are trading at a little less than 10x trailing earnings.

What has changed since GPRO was a $100 stock?

It’s not the company, although one might quibble that management must have known that 4Q15 would be problematic at least a month ago.

No, GPRO is still the same one-product niche firm whose chief protections from the predatory urges of much larger consumer products firms are:

–its first-mover advantage and

–the presumption that its target market is too small for the big boys to be interested in.

Yet that relatively thin story was worth 80-90x anticipated 2015 earnings in late 2014 and only 10x actual earnings now.

How so?

What’s changed is the tone of the stock market.  It was bullish/speculative in late 2014, meaning that market participants factored good news into stock prices and ignored bad–at times concentrating on the lipstick and ignoring the pig.  Today, buyers and sellers are much more alert to possible bad news and less interested in dreaming about how profitable the long-term future may be.

I don’t think the the more sober tone has much to do either with oil or China.  I think it’s all about preparing for a higher interest rate world.  Yes, to my mind, the market has now gone a little bit overboard on the negative side.  Still, I don’t expect a change in mood any time soon, maybe not until we’ve had one or two more interest rate hikes.

The lesson I take from GPRO, and the main reason I’m writing about it today, is that we should look long and hard at any stocks we hold where the main virtue is the long-term concept/story.   For a while at least, the market’s driving force will be PE, not the dream.