The Globe and Mail, Report on Business
Published April 1, 2011

By Tom Bradley

In Toronto last week, I was waiting for a friend at my Starbucks office. As I browsed the Sports section, I couldn’t help but overhear a nearby conversation between two investment types. The checked shirt was leading the discussion.

“My overweight in energy is really working. I’m 300 beeps ahead, even though my TE is sub 4. If this holds until quarter-end, my one-year number will be first quartile. I don’t know if it’s enough to get on any short lists though. My moving fours still suck.”

I was getting bored reading about the Leafs’ momentary playoff run, so I tried to descramble the jargon. What I think he said was: So far this quarter, his portfolio has achieved a return that is 3 per cent (300 basis points) better than the index he’s trying to beat. This has occurred because a larger percentage of his fund is invested in oil and gas stocks, which have done well, compared to the index.

Tracking error (TE) is a statistic that predicts how much the portfolio’s return is expected to deviate from the index – the lower the number, the more closely the portfolio will mirror the index.

I also picked up that if the shirt does okay in the remaining days of the quarter, his one-year return will look good and be in the top 25 per cent of funds he’s competing against. Unfortunately, one good year won’t be enough to make his longer-term results look attractive; specifically the four-year periods ending March 31, 2011, 2010, 2009 and possibly further back. The manager hasn’t been getting invited to compete for any new institutional accounts recently.

Unfortunately, the other geeky-looking guy was a bond manager. “It doesn’t make any sense to own Canada’s when I’m getting 75-80 beeps in Ontario’s. More of our risk budget is in provies than I can ever remember. Where I’m struggling is with the credit bucket. I want to sell some Trucks and Boats, but can’t find anything to replace them. I need something in the belly of the curve that’s better than bank paper.”

Bond talk is more challenging to translate, but I take it that Mr. Corduroys has a large position in provincial bonds in lieu of Government of Canada bonds. By holding Ontario, B.C. and other provincials, the fund is getting an extra yield of three-quarters of 1 per cent. In the corporate bond portion of the portfolio, he’s planning to sell specialized income securities issued by Royal Bank (“Trucks”) and BMO (“Boats”), but hasn’t figured out what to replace them with. In his opinion, the extra yield he gets by owning six- to 10-year bank bonds isn’t attractive enough to justify the risk.

As the lattes were disappearing, it became evident that I was the only one doing any listening. The shirt motored on.

“This focus on cheap beta is killing me. It’s all the consultants and media can talk about. That hottie from AON Mercer Towers keeps reminding me that index-like returns are free. She doesn’t seem to get that my fund doesn’t go down as much as her beloved XIUs. But I might have got through to her this time. The propeller heads did a chart for me that shows my bear capture at 73 per cent.”

Whoa, maybe bonds aren’t so bad after all.

Beta is an industry term used to describe the return of the overall market. For pension funds, and other large institutions, index investing (beta) can be done at an extremely low fee (a few hundredths of 1 per cent). On the other hand, active managers, who are out to beat the index funds, charge considerably more and are under pressure to justify their fees to clients and consultants (male and female).

Most active managers beat the indexes in weak markets, which can be shown by a ratio that statisticians call Bear Market Capture. In this example, the shirt’s portfolio had a bear capture of 73 – in down markets, it declined only 73 per cent as much as the index (as represented by the iShares exchange-traded fund – symbol XIU).

Thank goodness my friend arrived so we could relax and talk about the Canucks’ PK, Stevie’s triple double and where the Wildcats were seeded in the West regional. No translation required.