The Globe and Mail, Report on Business
Published October 27, 2007

My partners and I were bouncing around ideas this week for an advertising program. We weren't coming up with anything too brilliant and even starting to get a little punchy when Scott Ronalds, the brains behind our website, suggested the tagline "Concentrate Dammit." He was referring to our firm's most differentiating factor - our equity funds hold a limited number of stocks. They are concentrated on our managers' best ideas.

I start with this story because the design of our funds - and for that matter the raison d'être of Steadyhand - stems from the fact that so many funds today are handcuffed by rules and marketing labels. Value managers have to stick to value stocks and growth managers don't dare buy cheap, slow-growing companies. And there are diversification rules for both types of managers requiring them to own most or all of the industry sectors in the index.

For example, the manager of a Canadian equity fund might be required to own stocks in at least eight of the 10 industry sectors and be no more than 10 per cent above or below the index weighting. Through these constraints the fund managers get a not-so-subtle message: Stick to the advertised style and don't stray too far from the index.

A vast majority of the funds today have this benchmark orientation. Stock decisions are made in the context of the index that the fund is competing against. If energy stocks make up 27 per cent of the S&P/TSX Composite Index, managers base their energy exposure on that percentage. If they like the sector, their fund will be above 27 per cent (overweighted); if they don't, it will be under.

There are consequences to this focus on the benchmark. The managers end up owning securities that they don't like very much - filler stocks as I like to call them - because they are required or feel obligated to be in a sector. Filler stocks in turn lead to portfolio bloat because it takes a lot of stocks to match a portfolio to an index. Instead of holding 20 or 30 stocks that the manager really likes, the fund has 60, 80 or hundreds of stocks in it.

But the wealth management business is changing and I would suggest that the industry's benchmark orientation no longer fits the needs of its clients. Investors have more options today. They are diversified across a number of funds and managers, and are not just looking to replicate what is already in their portfolio. Indeed, with the emergence of cheap index product in the form of exchange traded funds (ETFs), investors that want an index-like return can get it for a fee of 0.25 to 0.35 per cent. If they are paying 2 per cent or more, however, they want a fund that is playing to win - a fund that truly reflects the views and insights of the money manager. In other words, no filler.

More often than not today's investors are not getting that. Once again, let's consider the energy example. If the manager thinks this part of the market is overpriced, the fund might have 20 per cent of its assets in oil and gas stocks. By being underweighted, the manager feels a significant bet is being made relative to the S&P/TSX (27 per cent), but the unitholders end up with a fifth of their investment deployed in stocks the manager doesn't necessarily like, and mightn't think of putting in a personal account. To my way of thinking, that approach doesn't justify a premium fee.

It's time the asset management industry realized that its fixation on benchmarks is breeding mediocrity and playing into the hands of the ETF and hedge fund companies. Fund managers own too many stocks and are satisfied with returns that compare to an arbitrary, passive and volatile portfolio, namely the market index. Indeed, a majority of equity funds fail to even keep up with the index. In the Canadian equity category on Globefund, there are 97 funds that have a 10-year record and only 33 of them beat the S&P/TSX Composite Index over that period.

It will not be an easy transition to make, but asset managers need to stop leaning so heavily on the index. They need to give their portfolio managers a bigger sandbox to play in so they have the scope and freedom to execute their ideas. They have to educate their clients in such a way that managers have a long enough time frame for strategies to play out. And they have to encourage the consulting community to be less rigid with its style categories and stop rewarding closet indexers.

I don't know if Scott's irreverence will turn into an advertisement or not, but he's definitely latched on to our biggest opportunity. While the industry is overweighted on benchmark returns, less constrained firms have a chance to build a base of clients that just want to "concentrate dammit."