Facing Reality by Questioning Some Common
Beliefs
February 3, 2015
by Ron Surz
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily
represent those of Advisor Perspectives.
There are many sides to reality. Choose the one that's best for you.
Eugene Ionesco, Rhinoceros
I’ve decided to do something different in this quarterly commentary. I begin as usual with a review of
first quarter market performance. Then I turn my attention to some commonly held beliefs that I regard
as mistaken, as shown in the figure below.
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Mistaken Belief
Reality
(1) Growth stocks have dominated in the
last 5 years.
Style providers have misclassified
fallen financials, distorting style index
returns.
(2) Active managers as a group always
underperform their passive indexes.
This phenomenon is exacerbated by a
procedural bias rather than ineptitude.
(3) Market indexes, like the S&P500 and
the Russell 3000, make the best
“Core” portfolios.
The very definition of “Core” is
violated by a market index. Even more
importantly, a true core index does a
lot of good.
(4) “Active share” predicts alpha.
Active share is a measure of
conviction, which may or may not add
value.
(5) Target date funds defend against
losses as the target date nears.
2008 proved that this is not true, and
little has changed since.
First quarter 2012 investment markets
Domestically, growth stocks were in favor, led by technology and financial companies. Outside the US,
smaller value companies led the way. I’ll review the year by analyzing why popular indexes, namely the
S&P500 and the EAFE, performed as they did. I provide StokTrib attribution analyses set against a
backdrop of the entire market.
US stock market
We begin with an analysis of the style composition and performance of the S&P 500, as shown in the
next exhibit. The total market returned 12.79%, about the same as the S&P’s 12.59%.
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The floating bars in the exhibit represent pure scientific peer groups described at Portfolio Opportunity
Distributions (PODs). The median of each POD is the return for that style in aggregate and the ranges
are the return opportunities for that style. Growth stocks of all sizes were in favor, returning about 16%
in the quarter. Large core was out of favor. This implies that pure growth and pure value managers
should have performed better than their more centric counterparts, like relative value and GARP
(growth at a reasonable price).
The dots plotted in the floating bars indicate that S&P performance is near median, and the bars at the
bottom of the exhibit show the S&P’s larger company orientation (red bars) versus the total market
(blue bars).
You can use this exhibit to rank individual managers within styles, as well as rank their style
components. Just plot your dots in the graph above. For example, locate your manager’s style in the
exhibit (large value, small growth, etc.), and place his or her rate-of-return within the corresponding
floating bar, using the scale on the left and the median from the table above as your guide. Voila, an
accurate ranking.
Next, I performed a similar analysis, decomposing the S&P by economic sector, and concluded that
both sector allocation and stock selection were in line with the total market.
Technology and financial stocks were in favor, returning 20.77% and 19.18% respectively. Note also
the tight distribution for technology and the wide distribution for financials, indicating the differing
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ranges of opportunities in these two sectors.
For an additional perspective, I analyzed the performance of the equal-weighted S&P in the quarter,
because there has been heightened interest in the equal-weighted S&P due in large part to
fundamental indexing. I found that it matched that of the cap-weighted index due to offsetting effects.
The following exhibit shows that the style allocation effects added value but this was offset by negative
stock selection effects.
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Non-US stock market
Now let’s turn our attention outside the US, where the total foreign market earned 11.5%, about the
same as the EAFE index, but 1% below the US market’s 12.5% return. As shown in the next exhibit,
EAFE underperformed the total foreign market in Europe, where smaller companies fared best, but
outperformed the total foreign market in Asia, where larger companies were in favor. The net result
was that the performance of EAFE was in line with the total foreign market.
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Exposing the myths
Let’s now turn to some mistaken beliefs that will lead to mistaken decisions.
(1) Growth stocks have dominated in the last five years.
Three years ago I started writing about the big disagreement in the style classification of fallen
financials. Indexes that use Price/Book as the classification variable, like Russell, view these stocks as
value while my Surz Style Pure® classification scheme sees these same stocks as growth because I
use Price/Earnings. I defended my position by noting that the book values of these fallen financials are
overstated because they have not been fully adjusted for bad debts.
Depending on where your view is regarding the recession, growth should lead value or vise versa. The
idea is that during a recession, safety and therefore value is in favor. Then as we recover, growth leads
the way. Did the recession really end in 2009?
A lot has happened in the past three years, including movement toward agreement. Surz Style Pure
classifications agreed with Russell prior to the 2008 meltdown, and then disagreed in 2008 through
2011, and now they agree again. They disagreed primarily because financials were classified by
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Russell as value and by Surz as growth, but now the Price/Earnings ratios of many of these stocks
place them into the Surz value style again.
As shown in the following style map, which uses Style Scan, Russell and Surz classifications have
migrated to agreement, primarily because the prices of the fallen financials have declined.
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Despite the current agreement, the history of disagreement remains in the performance results
forever. So why do you care? Investment managers are evaluated relative to their styles. In most
market environments it doesn’t matter much whose style definition you use, but that has not been the
case since the financial crisis began. Accordingly, a fair evaluation needs to address the proper
classification of distressed financials.
(2) Active managers as a group always underperform their passive indexes.
In “The Arithmetic of Active Management” (Jan/Feb 1991 Financial Analysts Journal) Dr. William
F. Sharpe described the tautology that active managers collectively will earn the market return, before
fees and transaction costs, so the expectation is that slightly more than half of managers will
underperform the market. But most performance reviews report that much more than half of the active
managers underperform their benchmark. For example, the “S&P Index Versus Active” Managers
scorecard (SPIVA) for periods ending December 2011 concluded that 80% of active growth managers
underperformed their benchmark over the past five years.
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Do you recognize this headline: “X% of Active Managers Underperformed Their Passive Index”? It
happens all the time, except sometimes it’s value managers and sometimes it’s growth – the pendulum
swings, and I can predict when it happens. It’s a peer group problem, not an incompetence issue.
When a style is out of favor, the majority of
managers in that style peer group will
outperform. When the style is in favor the
majority will underperform. For the last five
years the S&P 500 value index is down -3%
per year while the growth index is up 3%.
Most importantly, peer groups will mess you
up because they are loaded with biases,
including one particularly insidious bias that
most do not know or understand. It’s called
classification bias, and is described in detail
here. In a nutshell, the majority of funds in a
peer group, like large growth for example, do
not belong in that peer group, so when that
style is in favor, being out of that style is out
of favor, hence the majority underperforms
(please think about this). See the graphic
above. The situation gets shockingly worse
with hedge fund peer groups because each fund is unlike most of the other funds in that peer group.
As a result, funds rank well or poorly because they are misclassified rather than because they have
succeeded or failed, but what’s worse is that managers are hired and fired for the wrong reasons, so
clients suffer, as do the unjustly terminated managers. Should you fire 80% of the growth managers?
The contingency table in action
Classification bias creates a predictable relationship between manager performance and benchmark
performance, as follows:
When style is…
Pure Managers
Impure Managers
In Favor
Win
Lose
Out of Favor
Lose
Win
The “S&P Index Versus Active” Managers scorecard (SPIVA) for periods ending 2011 confirms this
dependency:
Percent of funds underperforming their benchmark
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Growth managers have been the big losers in the last five years but value managers were the losers in
the previous five years (from 2001 to 2006). Active managers appear to win when their style is out of
favor. Some interpret this fact as active managers defending best when their style is out of favor – they
shine when the going gets tough. This of course is not true. As you can see, the win-lose cycle has
everything to do with classification bias, and nothing to do with skill.
(3) Market indexes, like the S&P500 and the Russell 3000, make the best “core” portfolios.
There are two kinds of core investing: centric and blend. Blend is what we have been using for a long
time. It is most of the market, encompassing both value and growth, and is very popular: S&P 500 and
Russell 3000. But blend dilutes active manager decisions. It superimposes hundreds or thousands of
unwanted stocks upon active decisions, undermining their effectiveness. You may say that you want to
dilute active managers because you don’t trust them. But then you need to think through the wisdom of
hiring someone you don’t trust.
By contrast, centric core is the stuff in the middle, between value and growth. It is “true core.” Unlike
blend, centric is much less dilutive because it comprises stocks that active value and growth managers
can’t hold – they are outside the mandate. All 45 centric-core stocks are large, high-quality companies,
worthy of inclusion in most multi-manager portfolios.
Centric core is like a magic pill. Drop one into most portfolios and the benefits are too good to be true:
better diversification and higher returns, as summarized in the table below.
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Benefits of Centric (True) Core
Portfolios with
Blend Core
20% in Centric provides as much
diversification as 80% in blend.
Centric fills the void in most multimanager portfolios caused by the
4-corner solution.
The 45-stock Centric Core does not
dilute active managers, so more alpha
reaches the bottom line.
Centric smoothes the ride. Lows
will not be as low, but highs might
not be as high.
Diversification
Returns
Portfolios with
No Core
(4) “Active share” predicts alpha.
In 2007 Professors Martijn Cremers (Yale) and Antii Petajisto (New York University) published a study
entitled “How Active is Your Fund Manager? A New Measure That Predicts Performance,” inwhich
they concluded: Active Share predicts fund performance: funds with the highest Active Share
significantly outperform their benchmarks, both before and after expenses, and they exhibit strong
performance persistence. Non-index funds with the lowest Active Share underperform their
benchmarks. Active share is the percent of the portfolio holdings that do not match the benchmark’s
allocations.
Consequently, advisors are measuring active share, and seeking managers with a lot of it: the more,
the better. But be careful. Common sense dictates that nothing is that simple, certainly not determining
skill. Active share, like tracking error, is a measure of conviction, but conviction is not guaranteed to
produce results. Big bets can lead to big wins or big losses. To win, managers need conviction, and
(this is the big caveat) they need to be right. Something is categorically wrong with a study that
concludes that conviction alone is a predictor of future success. Life is just not that simple. Active
share is a fad, and like most fads, it will fade away.
It’s interesting how these fads work. In the 1990s the emphasis was on big bets: give me your best
shot, and I will diversify around you, like using a core portfolio. Then in the 2000s we decided that
tracking error was risk, so the four-corner solution emerged with its strong preference for style purity
with small bets. Now we’re back to preferring big bets.
(5) Target-date funds defend against losses as the target date nears
Despite beliefs to the contrary, target-date funds (TDFs) do not protect the vulnerable, namely those
nearing retirement. The year 2008 was a disaster, with the typical 2010 fund losing 25%, so there was
an outcry to avoid repeating this mistake in the future.
The 2011 performance of TDFs serves as a progress report on protecting the vulnerable. It showed
that little has changed, principally because the objective of TDFs has not changed; the (flawed)
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objective is to compensate for inadequate savings. For the most part TDFs did not defend in 2011. The
critical funds for this test are 2010, or “today”, funds because they are for people retiring between 2005
and 2015.
The graph above shows that only a handful of 2010 TDFs avoided loss in 2011. The next time could be
worse. Stock performance, as measured by the S&P 500, was a positive 2% in 2011, far better than
the 37% loss suffered in 2008. TDFs failed this simple and easy trial. The best performing funds in
2011 are those that emphasized safety at the target date. Such funds are in the minority. Most TDFs
are designed to compensate for inadequate savings by taking on unwarranted risk. In other words, the
objective for TDFs should be revised to safety-first, especially at the target date, but this has not
happened. The best way to compensate for inadequate savings is to encourage people to save more.
Academics have demonstrated that increased savings are far more effective than increased risk in
securing a standard of living in retirement. The job of TDFs should be to get participants safely to the
target date with appreciated assets intact.
The next graph below shows the various glide paths of TDFs. Please note the clustering of far-dated
funds. There is consensus on the appropriate risk for younger employees. The big disagreements
occur near the target date, when account balances are at their highest. TDF managers disagree about
risk exposure for the vulnerable. Note also in the following graph the tendency for equity shops to hold
more equities at target date than bond shops, suggesting that TDFs are packages of products rather
than solutions such as safety first.
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