What's Your PPR?

January 2, 2019
Yoshiki Obayashi

If you are responsible for evaluating and allocating capital to active managers, then you have arguably the hardest and most impactful job in the world of investing: managing a portfolio of managers, i.e. being a “manager PM.” There needs to be a rigorous framework to value, and language to discuss, the work of manager PMs.

An advancement in the study of manager portfolio management is key to channeling capital away from unskilled asset managers, and towards skilled asset managers who add true value not only to their investors but also by making passive investing viable for the rest.

Manager PMs

Most manager PMs work for asset owners such as pensions and foundations, and some for asset managers such as fund of funds and multi-manager hedge funds. As with an equity PM or bond PM, the work of a manager PM is to predict returns and manage risk. Instead of predicting security returns, a manager PM must predict the performance of managers who in turn attempt to predict security returns. What makes performance prediction particularly difficult is that chasing good past outcomes is ineffective because many are likely achieved by luck and will not persist.

At a more philosophical level, if it weren't difficult to predict which manager will beat the market net of fees, then any investor could beat the market, but such an equilibrium can’t exist. Investors are unfortunately not entitled to an exemption from the no free lunch rule just by paying somebody else to find said free lunches.

Manager PMs working for asset owners make allocation decisions on behalf of thousands of beneficiaries such as teachers, civil servants, and employees of corporations. The largest asset owners, some exceeding a trillion dollars, must allocate to dozens of managers and strategies due to capacity constraints and diversification requirements. In doing so, the selection and sizing of managers, whether internal or external, have an outsized impact on a plan's performance, far exceeding that of investment decisions made by any single manager.

Without Measurement, There is No Progress

Given the challenges and immense social importance of the role played by manager PMs, it stands to reason that a rigorous framework should be established to measure their performance and advance their practice. Such an initiative will help raise awareness that an asset owner CIO is running just as much of a prediction business as an asset manager CIO, since finding outperforming managers is at least as difficult as finding outperforming assets.

Quantifying the performance of manager PMs will moreover add much-needed clarity to the dialogue surrounding the viability and role of active management. An endowment blaming active managers for its poor performance should receive as much sympathy as a poorly-performing equity fund blaming the executives of companies whose stocks it bought. The active versus passive debate is a false dichotomy.

If investing in active managers is not working, then going passive makes sense, but not because passive is inherently better than active, just as sitting on your couch is not inherently better than going on a date. On the flip side, a successful manager PM should be as celebrated and well-compensated as a star hedge fund PM, if not more. I can’t read Warren Buffett’s mind, but I don’t think he advises regular folks to invest in passive index funds because he believes skilled managers, such as himself, don’t exist; rather, I think it’s because he understands how difficult they are to find.

“There are, of course, some skilled individuals who are highly likely to out-perform the S&P over long stretches. In my lifetime, though, I’ve identified – early on – only ten or so professionals that I expected would accomplish this feat.” - Warren Buffett, Berkshire Hathaway Inc. Annual Report 2017.

Performance Prediction Ratio

Most familiar performance metrics used for portfolios of securities can be adapted to portfolios of managers once parallels between the two are recognized. While an exhaustive exposition of such metrics is besides the point of this article, and shall be the subject of a future piece, one natural measure of prediction accuracy, which we call the Performance Prediction Ratio (PPR), is simply the information ratio, in terms of true value add, of the portfolio of managers with respect to an equally weighted portfolio of managers. A manager PM with the ability to predict relative performance of managers will have a high PPR, much like an equity PM with the ability to predict relative return of its benchmark's constituents will have a high IR.

It has taken institutional investors a couple of decades to learn the hard way that most active managers do not add value. But skilled managers who add value do exist, and it doesn’t do anyone any good to whine about the wealth-destroying unskilled managers because such rent-seekers are acting rationally in the presence of investors who are willing to pay them. The fact that some, including myself, find it distasteful is unfortunately irrelevant. What is needed is an advancement in the science of manager evaluation and performance prediction.

Who is able to find skilled managers? What’s your PPR?

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