The Globe and Mail, Report on Business
Published May 29, 2010

I’m just back from a few days in Scotland. Sightseeing, golf and a meeting with one of our equity managers was the order of the day.

For the golf, I stuck to convention and kept track of my pars, bogies and, unfortunately, the “others.” For my meeting with Edinburgh Partners Ltd., however, I threw out the industry scorecard. We had quite a different conversation from what normally occurs between manager and client.

What I mean is that we spent no time on short-term performance. None. We didn’t analyze where the fund is deviating from the global index with respect to returns or sector weightings. And we spent minimal time on the company’s economic outlook because that’s not what drives the makeup of our fund.

Instead, we discussed personnel changes and employee ownership. I wanted to determine how supportive and ethical the firm’s environment was for the investment team. We reviewed their investment philosophy and process, and the refinements they’ve been making. We touched on some stocks, but only to reinforce their approach and reveal what they do when things go wrong. I wanted to make sure the stiff backbone I hired three years ago was still there.

More than anything, I was watching to make sure EPL hadn’t slipped into being a benchmark-oriented manager. If Steadyhand is going to deliver better returns than other firms, we need to look different than the indexes. As David Swensen, chief investment officer at Yale University, puts it: “Market-beating managers express their insights in concentrated portfolios that differ dramatically from the character of the broad market.”

A 2006 study by two Yale academics (Martijn Cremers and Antti Petajisto) confirmed that view. It concluded that funds which deviated most from the index outperformed their benchmarks (on average) while funds that ran closer to it did not. Interestingly, the study also pointed out that in the United States the proportion of passive funds claiming to be active (closet index funds) increased from zero in 1990 to 30 per cent in 2003.

Despite evidence pointing in the other direction, managers are sucked into the benchmark world by three irresistible forces – risk management systems, clients and success.

It’s a relative world

Risk management systems can be a useful tool. They confirm the types of risk being taken and make sure the portfolio properly reflects the managers’ views. But the problem with all the fancy numbers is that they’re short-term oriented and strictly based on comparisons to the market indexes, however flawed they may be. And instead of providing a reality check, they often take on a life of their own and start to shape the portfolio.

So with the industry scorecard based on how funds look compared to the index, it’s not surprising the managers know the makeup of that index by heart, to the decimal point. Or that they begin managing to a “tracking error” number (a statistic that estimates how much the portfolio’s return will deviate from the index, based on historical data). Or that they start speaking unintelligibly in a secret language – “I’m overweighted consumer staples and underweighted materials.” All signs that the index is near.

Clients and their concerns

Managers are hired to beat the benchmark. Unfortunately, the quarterly comparisons they go through with clients make it more difficult to do. The performance analysis on stock and sector weightings is all done relative to the index. And it’s always for periods of one year or less.

It’s clear where the portfolio did well and where it fell short. If the manager is pursuing a long-term strategy that hasn’t played out yet, a few quarters can feel like a lifetime. There are only so many ways you can say, “The fund has underperformed because it owns a ton of technology stocks and no oil.” So every tough client meeting pulls the manager closer to the closet.

Bonus pools and redemptions

In light of the risk management and client pressures, a fund manager is forced to find a balance between where their research and conviction is pointing them and what the index looks like. How much can they deviate and for how long.

The stakes can be high for the manager (a big bonus versus no job) and the firm (more clients versus redemptions). The higher the compensation and larger the firm, the more there is to protect. Managers find themselves owning “filler” stocks – ones they don’t like much, but keep the fund from straying too far from the index.

Fortunately, I left Scotland knowing that our fund will continue to look different. The EPL team runs concentrated portfolios (30 to 40 stocks), designs their risk management around factors that don’t strictly relate to the index, and is careful to sell themselves as the “undexers” that they are.

I also left knowing that my golf game needs serious work. It’s overweighted sand, underweighted one-putts and subject to extreme tracking error.