You can’t eat relative performance
This essay appeared in Citywire Selector on June 29, 2010.
First, a little ‘selector humour’…
After a full day of intense meetings with managers in London, two selectors stop in a pub to unwind.
‘What can I get for you gentlemen?’ asks the bartender as the selectors take their seats.
In the mood for beer, the first selector orders an ‘Absolute,’ while the second orders a ‘Relative’.
Hearing his colleague’s order, the first selector and the bartender start to laugh and exclaim: ‘Come on, we all know you can’t drink Relative Beer!’
The ‘joke’ above illustrates one of the major issues selectors are facing today. It is based on the oft-repeated phrase in our industry, ‘You can’t eat relative performance.’ It properly describes the key criticism and limitation of the relative return approach to investing: ‘outperforming’ in negative markets, that is, being down 20% when the market is down 30% is still losing money. True enough.
So why then do thousands of managers around the world keep trying to outperform market indices? Are selectors unnecessarily going hungry (or thirsty), ordering relative return funds when they should be spending their time focusing elsewhere? Is trying to outperform indices composed of risk assets simply making the job of managing money more difficult than it needs to be?
As selectors, we know these questions are both important and complex. The Newcits funds launched almost daily are forcing all industry participants to reconsider their positions. Many ‘pre-Newcits era’ funds are now dinosaurs in the minds of professional buyers. They are fat and slow. They are the source capital for purchasing the new generation of funds. These dinosaurs and the managers who run them must adapt or die.
Demand for low-tracking error relative return funds –‘benchmark huggers’ – has all but dried up. Selectors want truly active managers able to navigate difficult environments and demonstrate talent.
Selectors are less focused on style purity and sticking to the box. Funds with absolute return targets that use innovative and flexible approaches are in full scope. Yet at the same time, we are not comfortable simply handing over investors’ money to managers and setting them free to do as they see fit in the pursuit of returns – absolute or otherwise.
There is a delicate balance to be struck. We want transparency and predictability. We want innovation and new insights. We want funds that capture the upside of the market and avoid or make money during downturns. But at the same time, we want to know that what we buy will remain consistent with our expectations long after the initial purchase.
We are only willing to pay performance fees when it is reasonable. Further, we still need to be able to implement an asset allocation strategy often set by an entity other than the selection unit – this complicates matters.
Of course there is a big ‘grey area’ between my polar descriptions of absolute and relative approaches. The majority of managers fit somewhere well in between the bookends. But for illustration purposes, let’s further contrast the two types of approaches in their ‘pure’ forms.
Conventionally, relative return managers have had to provide both market exposure and manage for outperformance. In managing a fund, they must:
– Identify and properly allocate to what will be the winners within their universe of stocks (which should closely reflect their benchmark index’s holdings).
– Identify and not allocate to the losers within their universe.
– Manage relative stock, industry and sector weightings.
– Keep tabs on the positioning of the benchmark index – although not necessarily sticking to it strictly.
– Keep track of their peers (with whom they are readily and often compared).
– Provide and take in cash on a daily basis (new investments/redemptions). In a fully invested portfolio, a relative return manager will always have a small cash position which, in rising markets, is a drag on performance. Of course the 2-5% ‘frictional’ cash position can also help performance in turbulent times, but holding cash long term works against a manager.
A relative return approach holds its target benchmark index as its ‘neutral’ (or not actively) invested position. On day one, in minimising the risks against the benchmark, the manager is fully exposed to the true risks of the market – losing money. On the other hand, an absolute return approach assumes the risk-free rate or ‘cash’ as the neutral, non-actively invested portfolio position. This distinction is important not only for how a particular fund is managed, but how the fund manager is compensated.
Performance fees are a key aspect of absolute return investing and increasingly common throughout the industry. Properly applied, performance fees align the interests of the manager with the investor. Improperly applied, they can be unjustified, and a massive drain on performance delivered to investors’ pockets. Fees are under scrutiny. Paying a 20% performance fee for returns above cash to a manager running a long-biased emerging markets equity fund is rich by any calculation.
At the other end of the spectrum, managers with an absolute return target (again, in its purest form) have to do virtually none of the above-listed exercises that conventional relative return managers undertake. They have a lot of flexibility. They can potentially go long or short. They can use leverage and buy instruments from a much broader universe. Funds can be quite concentrated and, when deemed prudent, they can go to cash. On top of that, they earn 20% of performance above a hurdle, potentially as low as cash. Your average relative return manager really seems to have a tough job by comparison!