A Math Problem

Posted on February 27, 2017

Author Name By Troy Brown, CFA

Without revealing or claiming an ideology, I will admit I get most of my news from watching and reading sources that are largely contrary to my leanings. Whether it’s the hypocrisy of one side blaming the other for all of the country’s ills or the 24-hour sound-bite society we all live in, the result is usually frustration and disappointment. If I kept this conflict to myself the story would be over but this self-imposed, semi-tortured state often leads me to vent to my family at the dinner table. The predictable question that usually comes back is “why do you watch/read it if it makes you upset?” While I cannot argue with the question’s basic logic, I would contend it’s always a healthy exercise to view things from a different angle in order to gain a stronger overall understanding of how things work. I would also posit taking in information that only supports your current worldview results in a rather rigid mindset and existence. Get ready to experience a shift in perspective by considering the following theoretical scenario…

An investment committee makes the decision to hire an active large cap core equity manager for a competitive 0.55% (55 basis points in industry-speak) annual fee. In the first year of engagement, the manager is able to generate a gross of fee return of 11.0% versus an S&P 500 Index return of 10.0%. On an absolute basis, the resulting 45 basis points of net outperformance logically makes the committee feel good about the hiring decision and the manager. Let’s dig a little deeper…

Now what if I told the committee that the first 10% of their manager’s performance was actually “free” (almost)? This reality exists since an average investor can quickly and easily gain 100% exposure to the performance of the S&P 500 index for 5 basis points (or less). Breaking down the math, since roughly 91% (10.0% / 11.0%) of the portfolio’s total return of 11.0% for the period has a cost of 5 basis points, the committee essentially paid 50 basis points (0.55% – 0.05%) for the additional 1.0% (the portion of the 11.0% return attributable to the manager’s skill) return the active manager was able to earn above the index’s return of 10.0%. As a result, without changing any of the scenario’s parameters (just viewing the results from a different angle), the manager’s reasonable 55 basis point fee just turned into a 50% performance charge on the portfolio’s 1.0% gross outperformance. To compound the uneasiness that you may be feeling, we all know even truly skilled managers do not always outperform their benchmark index. Unfortunately, when this is the case the math tilts exponentially against the investor since the committee is paying a 55 basis point “skill-based” fee regardless of the manager’s result. Let’s keep digging…

Before the committee in our hypothetical scenario gathers the torches and pitchforks to lead the charge against active management, it is important to remember that the portfolio did generate outperformance (a valuable skill worth paying for), which the committee likely could not have achieved on their own. Outside of this scenario, skill is not just about outperformance, an active manager may offer downside protection and/or reduce volatility relative to a passive benchmark. In either case, it’s simply a math problem: what is “active manager skill” worth? Additionally, how can investors level the playing field so that inevitable periods of underperformance have a lower impact on the portfolio, encourage committee patience, and prevent poor decision making? For committees willing to commit the time and effort, the answer may be implementing a performance-based fee structure for their active managers where appropriate. Operational challenges aside, in a skill-based and measurable profession, the only managers not comfortable being evaluated and compensated for their net positive contribution are logically those not convinced they are truly adding value.

Before closing, let me make one thing perfectly clear: while there are ebbs and flows in investor preferences and the saliency of arguments for active and passive management, it is not (and should not be) an either/or tradeoff in the minds of investors. Active and passive investment strategies can, and should, effortlessly coexist in the capital markets and investor portfolios. Further, large cap core active management makes an easy target for this scenario since this particular segment of the market is arguably the most efficient when compared to others. Ironically, much of this market efficiency is driven by the critical price discovery of competing active managers. Other market segments and asset classes do not necessarily share this efficiency nor are they advisable to access on a passive basis from our perspective. See, we can all get along.

 

This blog is provided for informational purposes only and should not be regarded as investment advice or as a recommendation regarding any particular course of action.