Before getting to the solution, it’s important to first recognize where the passive index-based benchmarking of active managers goes wrong. The crux of the problem is that a broad market index being the widely-accepted passive alternative to an active manager is not the same as being the correct baseline against which to measure the manager’s performance. While understandable, conflating these two distinct concepts leads to an incorrect view of a manager’s value add.
To measure the value added by a manager, an investor must contrast the manager’s performance with the alternative outcome of not investing in this manager. While conceptually straightforward, this is an intractable problem at such a level of generality because alternatives to investing in a particular manager include everything from trading classic Porsches to flipping houses. Surely the return on a garage full of Porsche 911s is not a sensible point of comparison for a European small cap manager.
The industry’s long-standing solution has been to designate the performance of a broad-based “benchmark” index as the pertinent alternative outcome. The index is typically chosen ad hoc by some loose association with the manager’s investment universe and sometimes “style.” To no one’s surprise, managers and investors routinely find themselves writhing in the subjectivity of the benchmark selection process, but the fault in this practice lurks at a deeper level.
Passive Investing is Not the “Opposite” of Active Investing
The concept of passive investing has been artfully cultivated since the 1970s to convince investors that the unique alternative to active management is to invest in funds that track broad, capitalization-weighted indices. While the existence of passive funds undoubtedly benefits the average investor, this influential concept has created an unintended, critical flaw in the way investors evaluate managers. A stumble in logic so subtle that it has gone undetected for decades while causing invisible cracks in the foundation of active management.
The flaw arises from investors equating the expected outcome of a manager making no active decisions to the performance of a fund tracking the manager’s benchmark index. The latter being the investor’s “passive” alternative does not make it the outcome of any specific manager without her active decisions. If that is still too subtle and abstract, some concrete examples should help.
Suppose Mortimer is mandated to invest in US large caps with a maximum exposure of 2% to TMT, minimum ADV of $3.5 million, position limit of 60, and is assigned the S&P 500 as his benchmark. Such a scenario probably seems reasonable to most investors. Yet, the S&P 500 violates the constraints in his mandate, so Mortimer is not even allowed to hold the benchmark portfolio. Put another way, it’s logically impossible for this benchmark to represent the outcome of stripping Mortimer of his active decisions. Then, how could it be fair to horse race Mortimer against this index?
Now suppose Randolph is also mandated to invest in US large caps but with minimum market cap of $3 billion, maximum exposure of 1% to financials, and is likewise assigned the S&P 500 as his benchmark. Like Mortimer, Randolph is being pitted against a portfolio that he is not even allowed to hold. There’s an additional paradox here as investors are now measuring two managers with meaningfully different tasks with the same yardstick. Commonly seen “peer group analysis” that compares Mortimer's and Randolph's excess return over their common benchmark is an apples-to-oranges exercise that is horribly misleading.
No, Passive Benchmarks are Not “Close Enough”
If the examples of Mortimer and Randolph come across as pedantic and not amounting to grounds for dismantling the status quo, the second part of this series will disabuse you of such a notion. Excess returns over traditional benchmarks, or “alpha,” is an invalid measure of a manager’s value-add that has likely caused, and continues to cause, trillions of dollars to be inefficiently allocated and hundreds of billions in misspent fees. A seemingly innocuous, almost trivial, error in logic has helped perpetuate adverse wealth transfers of immeasurable proportions among investors and managers.
To properly isolate the value added by a manager—by her active decisions, to be more precise--the alternative outcome that must be quantified is the expected performance of the hapless hypothetical twin who is tasked with the same job but has no skill in investing. The astute reader may have already begun understanding the importance of mandates in creating the true benchmark. The next part of this series will explain how to measure true value add.
The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the views of Applied Academics LLC or any of its affiliates.
Photograph by Mikihiko Obayashi