Portfolio Management’s Conventional Understanding
Conventionally, portfolio management is a process of weighting multiple securities in an attempt to increase the amount of return per unit of risk taken on. I am intentionally not mentioning Modern Portfolio Theory; though, that is one approach. Earlier in this series I dissected why I believe the principles behind MPT are appropriate (maximize return per unit of risk), or colloquially: “do not put all of your eggs in one basket.” But, I completely disagree that volatility is a legit measure of risk.
Not putting all of our eggs in one basket is almost always thought of as a risk minimization strategy. However, there is also a returns story to be told here, too. Namely, because the future is unknowable (hence a concern with eggs and baskets) we also do not know what securities will perform well either. Thus, choosing more than one security increases our optionality; specifically, the number of our call options. But then there is that omnipresent specter: what is the probability that our choices of which securities from among many, and at what weights, are likely to outperform (e.g. a benchmark, a 10-year government bond, inflation, some other target)?
Sadly, the data do not support that, on average, the investment industry is good at portfolio management at all. In our recent co-authored book, Return of the Active Manager (ROAM), Tom Howard and I share the results of multiple pieces of research demonstrating inconvenient facts. First of all, not surprisingly, we find the conventional result: active management taken as a whole does not add alpha. Zzzzz.
What we do report are the results of multiple studies that show something surprising. Namely, research analysts, on average, add alpha of 130 bps (Wermers, 2000). Not recent enough for you? Separate research found that approximately 80% of equity investment managers display skill enough to cover their fees (if they do not asset bloat). Still not recent enough? In 2018, an exhaustive meta-analysis (a study of lots of studies) concluded:
“While the debate between active and passive is not settled and many research challenges remain, we conclude that the current academic literature finds active management more promising for investors than the conventional wisdom claims (Cremers, Fulkerson, and Riley).”
Wait, I thought you said, Jason, that this was inconvenient data. It is. The reason is that we need an explanation for why it is that deep dive research consistently finds that research analysts add value, but that overall fund performance is terrible. Another study provides a painful answer. Namely, the top 20 holdings in funds provide 160 to 210 bps of alpha, but that portfolio management kills all of the alpha, and then some (Cohen, Polk, & Silli, 2010). Yikes!
This is why I can confidently declare that portfolio management is among the most misunderstood investing topics.
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Portfolio Management, Slight Return
So, what should portfolio management be about? I think it should be about what it has always been about: maximum returns for the minimum amount of risks. But the misunderstanding is about what activities actually fulfill that mandate.
On the returns front, remember above that research analysts actually add considerable alpha. Isn’t that an argument for increasing the influence of their work on the construction of portfolios? If you agree, then it means the following:
- Reduce the number of holdings in the portfolio so that only high conviction securities are present.
- Ask analysts for portfolio weighting recommendations. But gather the data. Do weighting decisions, the portfolio managers or the analysts, add alpha? Probably not.
- If there is no evidence of alpha added by portfolio weighting decisions, then why not equal-weight? In my consulting work, equal-weight almost always outperforms other schemes.
On the risks front, there are also value-add activities. For starters, notice that I, first, reminded you that volatility is not risk, and second, I have used the plural ‘risks’ throughout, and not the singular, ‘risk.’ Why? At the risk (pun intended) of giving away a tremendous portfolio management secret and not earning a proper living based on the quality of my thinking, it is because risk management is already embedded in your research analysts’ assessment of securities. So, then, what is missing? Here I am going to be coy. But a hint is that making decisions based on covariance, beta, volatility (including semi-variance), and the like do not add/preserve alpha at the portfolio level. But other activities do.
Role of the Portfolio Manager
All of the preceding points are existential and hiding there in plain sight is a question: what is a portfolio manager good for? Here are some thoughts.
- It is likely that the portfolio manager has more experience than the average tenure of the research analysts. This repository of “know how” and problem solving is an invaluable asset when confronting new or Black Swan events.
- Devil’s Advocate. Portfolio managers add value by ensuring that research analyst ideas are properly vetted. A second set of eyes, an attitude of increasing the signal to noise ratio, and ensuring objectivity is maximized, are all very valuable contributions by portfolio managers. Last, if they are wise about behavioral biases, they can ensure that these are not the sins of their teams.
- Highly talented research analysts frequently are very creative. Almost by definition, creative people are contrarian. A consulting friend of mine says these people are Magicians, and that they always need protection. But even non-“mad scientist” research analysts need buffering from the politics of organizations. This means that their time is spent doing what they do best. Not only that, they can create environments for success and thriving for their teams.
- Portfolio managers can impart the details of their know-how to their teams. What is more, if they are creative and good at identifying what is missing, they can help guide the improvement of their team members.
- Tough decisions. When the going gets tough, the talented portfolio manager can be relied upon to make a tough decision. This could be: a tie-breaking vote when the analyst is 50:50; to buy when the chips are down; or to sell when the analyst has fallen in love with a loser.
- In my experience, high quality portfolio managers have high levels of intuition.
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