Indexology^® Blog

Some active managers argue that the remedy for widespread active underperformance is more aggressive, more concentrated portfolios.  If this is the correct prescription, it has a number of adverse side effects — for example, risk is likely to increase, and the relative importance of skill and luck in decision making is likely to shift in luck’s favor.

A third consequence is that trading costs are likely to increase significantly.  This is because — with more concentrated portfolios — both fund turnover and cost-per-trade should rise. Here’s a simplified example:  Two managers share the same security rankings but construct their portfolios differently.  The first manager selects the top-ranked 10% of the universe, and operates the more concentrated fund. The second manager excludes the bottom-ranked 10% of the universe (and therefore holds the top-ranked 90%).  Suppose that in each quarter there is X% turnover in the securities ranked in the top 10% and the same X% turnover among the worst 10%.

Consider the turnover required for each manager, assuming that their portfolios are equally weighted and that they both rebalance once per quarter:

• The concentrated manager holds the top 10% of the universe.  His turnover will therefore be X%.
• The diversified manager holds everything but the bottom 10%. There is X% turnover in the stocks he doesn’t own, which leads to a turnover of (X/9)% in those he does.

In this scenario, the concentrated manager’s turnover is nine times higher than the diversified manager’s turnover.  Of course, the specifics depend on what fraction of the universe each manager chooses to hold.  (With quintiles instead of deciles, the concentrated manager’s turnover would be “only” four times higher than the diversified manager’s.)  But it’s difficult to escape the conclusion that turnover will rise as concentration rises.

Moreover, transaction costs per trade are also likely to rise.  Transaction costs are not linear: it typically costs more to trade a higher percentage of the outstanding float in a security.  Otherwise said, a manager is likely to be able to purchase 10,000 shares in each of 100 companies with less market impact than he could buy 1,000,000 shares of a single company.

Thus, higher concentration can deliver a double blow to returns: higher turnover and a higher unit cost of execution.

The debate over which sector of municipal bonds, general obligation bonds (G.O.’s) or revenue bonds can provide a better return is a constant one.  So far in 2016, the S&P Municipal Bond Revenue Index has outperformed verses the S&P Municipal Bond General Obligation Index.

Peeling the onion back a bit may help provide more insights.

• In general, revenue bonds have a higher coupon and higher yield than general obligation bonds so that is a factor in return performance under normal market conditions.  Year to date the G.O.’s have returned 3.49% while revenue bonds have returned 4.7%.
• While revenue bonds have indeed outperformed, the bond issues that are below investment grade revenue bonds are also a contributing factor.  The S&P Municipal Bond High Yield Ex-Puerto Rico Index is up over 7.3% year-to-date and the majority of those bonds are revenue bonds and not general obligation bonds.  In contrast, the S&P Municipal Bond Investment Grade Index which includes both G.O.’s and revenue bonds has returned over 3.8% year-to-date.  (Note: Selected the S&P Municipal Bond High Yield Ex-Puerto Rico Index as Puerto Rico revenue bonds have seen a significant rebound in 2016 and would further skew the results).

Select municipal bond indices, their yields and total returns:

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House sales and prices are rising.  Home sales in June were 5.57 million at annual rates, the highest since February 2007 when national home prices peaked.  Currently prices as measured by the S&P/Case-Shiller National Home Price Index are climbing at a 5% annual rate and are a mere 3% from their all-time peak.

What next?  The next S&P/Case-Shiller Home Price Index report will be released on Tuesday morning at 9 AM – check to see if the advance continues.  The data will be posted at www.spdji.com.

Is the remedy for active managers’ well-known performance difficulties to become more active? Some observers think so, and argue that less diversified, more concentrated portfolios should be the wave of active management’s future.  But there are a number of adverse consequences to concentration — for example, risk is likely to increase.   A second consequence is that in manager evaluation, the importance of luck will increase relative to the importance of skill.

While some managers may be skillful, none are infallible.  A manager who is skillful but not infallible will benefit from having more, rather than fewer, opportunities to display his skill.  A useful analogy is to the house in a casino: on any given spin of the roulette wheel, the house has a small likelihood of winning; over thousands of spins, the house’s advantage is overwhelming.

The chart below illustrates the concept.  In a coin-flipping game with a biased coin, we “win”  if more than half our tosses come up heads.  We play with two coins, with a 53% and a 55% chance of heads.  The probability of winning grows as the number of tosses rises and, for any number of tosses, the chance of winning is higher with the more favorable coin.  However, if the number of tosses varies between the two coins, at some point, it is preferable to have a worse coin and more tosses.

The analogy to security selection is straightforward: instead of flipping a coin, a manager picks stocks with a given probability of outperforming the market.  If more than half his picks outperform, the manager “wins” the game.  The more picks he makes, the more likely it is that his skill dominates his luck.  As with the coin-flipping game, for a constant number of stocks, a more skillful manager is more likely to outperform than a less skillful manager.  But if the number of picks varies, an asset owner may be more likely to outperform with a less skillful manager who holds more stocks.

An unskilled manager has a better chance of winning the game the smaller the number of tosses (just as a skilled manager has a better chance the more he tosses).  Concentrating portfolios makes it more likely that good managers will look bad, more likely that bad managers will look good, and more likely that asset owners’ decisions will be informed by luck rather than skill.

As we approach August, the U.S. bond markets have extended their malformed shape despite another round of chatter about the possibility of a Fed hike, this time towards year end.  Subsequent to the June 2^nd, 2016 blog Bond Market Malformation, Trouble Ahead? bond yields have compressed further.

Demand continues to outstrip the supply of U.S. investment grade corporate and municipal bond issues as investors seek incremental yield over Treasuries and safe harbors (risk off) during volatile periods. The result bond prices have continued to rise and yields have fallen.

• Record low municipal yields: The weighted average yield of bonds in the S&P Municipal Bond Index hit a low point not seen before in its 15 year life as the yield to worst (YTW) reached a low point on July 8th of 1.687%.
• The Taxable Equivalent Yield of the bonds in the S&P Municipal Bond Index is currently right on top of the yield of the corporate bonds in the S&P 500 Bond Index.

Chart 1: Select bond indices and yields (yield to worst):