This “case study” is taken from a piece that I wrote for a client who found it too negative. It describes the way that many “active” equity portfolios are managed. It may seem like a caricature to some, unfortunately it is not. Thus, it is not surprising that so many fail to perform.
Consider a typical active global equity team, supported by sector analysts, managing a portfolio with standard investment guidelines for an institution. Its objective is to beat the MSCI World index over a three year horizon.
The analysts provide the portfolio constructors with lists of their best ideas within their assigned sectors. There will often be many more names on the lists than are “needed” for the portfolio. Thus, the portfolio managers have to choose from among the analyst recommendations. Given that the portfolio managers know rather less about the names on the list than the analysts do, one may wonder whether this selection process is likely to add value. The optimal use of the information contained in the analysts’ recommendation would be to invest in all of them but that would lead to large portfolios and many investors believe that only concentrated portfolios are truly “active”.
There is an interesting empirical study on the question of value added by traditional active portfolio managers. A well-known Boston-based fund house runs dozens of sector funds and hundreds of multi-sector funds. The author of the study compared the performance of every multi-sector fund with that of a (theoretical) portfolio made up of sector funds with the same sector weights as the multi-sector fund portfolio. If the multi-sector funds had outperformed the portfolio of sector funds, the portfolio managers would have added value, on average. But it was the specialists who won: the portfolios of sector funds outperformed by just under 3 per cent p.a. over a ten year period, on average. Cherry-picking stocks from a list of analyst recommendations appears to be very challenging.
But there is worse: most analyst teams are too small to provide credible coverage of all regions and all sectors around the globe. Consequently, the analysts’ “best idea” list will most likely have holes: some sectors in some regions may not be covered or covered badly. It would be rational to fill these holes with a diversified ETF or a future. But that is not what typically happens: instead, a “safe” mega cap or two are bought to fill in the holes.
The portfolio construction team has often no choice but to fill the holes. Client guidelines usually include a relatively low tracking error limit. Consequently, the portfolio must have some exposure to most industries and most countries within a region. This results in “forced bets”: the portfolio must be invested even in those parts of its investment universe about which the managers know little or nothing. Again, this is unlikely to impact performance positively. Thus, tight client guidelines may have a direct negative performance impact.
If the investment team also engages in sectoral or regional bets, things become really complicated. The rational way to express a sector or regional bet would be through a long position in an ETF in the sector/region to be overweighted offset by a short position in the sector/region to be underweighted. But this is not possible in a long only portfolio. So the portfolio managers have no choice but to play sectors or regions by adjusting the weight of individual stocks – potentially undoing promising bets proposed by the analysts at least partially. In the worst of cases, the team may be correct in its sector or regional view but, because of poor stock selection, the portfolio may not benefit. There is no efficient, rational way to incorporate sector and regional bets into a long only stock portfolio; the different sets of bets will tend to contaminate each other.
If a portfolio construction team wants to exploit all possible sources of added value – stock, sector and regional bets as well as market timing – with a long-only portfolio without derivatives, it is likely to be overwhelmed. This is not surprising given that it is playing a rather more complex game than the analysts. While an analyst needs to assess the relative prospects of, say, one machinery producer and another one, portfolio constructors must also assess the relative prospects of, say, a bank and a tech company – while juggling all the other types of bets that the portfolio contains as well. As a result, the typical active global equity portfolio is not primarily a collection of “best ideas” but is rather a complex hodgepodge of bets – many forced on the managers by tracking error considerations.
If judgmental teams do not have access to sophisticated quantitative risk management tools or are not comfortable using them, their portfolio is also likely to contain a number of unintended side bets on various risk factors stemming from the team’s strategic or cognitive biases.
To summarise, there is some evidence that skilled, experienced analysts can separate future winners from losers within sectors. But that added value is then typically partially or entirely destroyed in the portfolio construction process, which is overly ambitious, unnecessarily complex, yet too primitive to give the portfolio construction team a reasonable chance to perform well. Not surprisingly, portfolio construction teams often show little conviction in their bets, which they abandon at the first sign of trouble. The resulting high turnover is another drain on performance.
There are obviously successful global equity investors. But they are and will remain a small minority. There is a bright side to all this: we know that, in order to add value, winners need losers. Traditional active equity management will continue to provide a generous supply of losers for those who are willing to do things differently.
 Scala, Nicholas, 2010, “Are Sector Fund Managers Superior Stock Selectors?”, working paper.
 Clarke, de Silva and Thorley showed in a 2002 paper that the performance potential of skilled active investors is greatly reduced in long-only portfolios and by tight tracking error limits: well over half of the potential value added may disappear.