Yesterday’s Wall Street Journal offered a profile of fixed income investors who aim to “break [the] chains” by which they are supposedly confined by index benchmarks.
As the bond market falters, investors are seeking shelter in funds that aren’t tied to indexes. These bonds funds are known as “unconstrained,” “go-anywhere,” “absolute return” or “flexible” funds, and they are gaining in popularity on both sides of the Atlantic…
This echoes a theme we also hear in the equity markets — that managers need to be “more aggressive” (typically by holding fewer stocks) in order to improve their performance.
Improving performance is not quite as easy as the article implies. Moreover, investors, both institutional and individual, compare managers to indices for a very good reason. The reason is that absent some objective standard, the fund owner has no way to judge whether the asset manager’s performance was good, bad, or indifferent. Admittedly, “some objective standard” covers a lot of ground — not losing money in a quarter, or earning at least 10% a year, are both objective standards. But indices are uniquely well-suited to be the standard by which asset owners evaluate asset managers.
Most broad market indices — whether they measure equities or bonds — are capitalization-weighted. Such an index will accurately reflect changes in the total market value of the asset class in question. One of the most important characteristics of any asset class is that there is no net supply of alpha. In other words, one manager can be above average only if another manager is below average. The aggregate amount by which the above-average managers outperform the asset class must equal the aggregate amount by which the below-average managers underperform.
By comparing manager performance to that of a well-diversified, cap-weighted index, an asset owner realizes two benefits:
- He assures himself that his bogey is reasonable in view of the opportunity set available to his managers. In 2011, with the S&P 500 up 2%, it would have been foolish to expect a U.S. equity manager to meet an absolute 10% bogey. This year, with the 500 up 29% through November 30, it would be equally foolish to be satisfied with 10%.
- Since there is no net supply of alpha, roughly half of all managers will outperform their asset class and roughly half will underperform. As a convenient shorthand, a manager who beats a well-diversified cap-weighted index is likely to be an above-average manager.
There are as many putative paths to outperformance as there are active managers (or active managers’ marketing departments, which is more or less the same thing). None of them will be impeded by asset owners’ use of well-chosen indices to evaluate manager performance.