{"id":5440,"date":"2015-07-28T09:40:43","date_gmt":"2015-07-28T13:40:43","guid":{"rendered":"http:\/\/www.jasonapollovoss.local\/?p=5440"},"modified":"2018-09-21T02:03:44","modified_gmt":"2018-09-21T06:03:44","slug":"alpha-wounds-benchmark-tail-wags-the-portfolio-management-dog","status":"publish","type":"post","link":"https:\/\/jasonapollovoss.com\/web\/2015\/07\/28\/alpha-wounds-benchmark-tail-wags-the-portfolio-management-dog\/","title":{"rendered":"Alpha Wounds: Benchmark Tail Wags the Portfolio Management Dog"},"content":{"rendered":"

Active management is under siege from many corners, including passive investment advocates, robo-advisers, academics, and individual investors. The narrative, of course, is that active managers add no alpha after fees. Is active management dead? Hardly. But\u00a0active management is certainly wounded. And many of these alpha wounds are self-inflicted.<\/span><\/p>\n

This and other forthcoming articles<\/a> will seek to identify some of these wounds and propose some possible solutions for practitioners of active management.<\/span><\/p>\n

Benchmark Tail Wags the Portfolio Management Dog<\/strong><\/span><\/p>\n

Chief among the alpha wounds is that the benchmark tail wags the portfolio management dog. What I mean is that benchmarks were supposed to be the foundation for understanding a portfolio manager\u2019s performance after the fact<\/em>. Instead the investment industry evolved so that benchmarks are now the navigational compass for investment managers before the fact<\/em>.<\/span><\/p>\n

How else do you explain a common conversation overheard in our industry that goes something like:<\/span><\/p>\n

Pension Fund:<\/strong>\u00a0“We need a new large-cap core manager. Our old one has too much tracking error relative to bench.”<\/span><\/p>\n

So how did we arrive at benchmark idolatry?<\/span><\/p>\n

A Brief History of the Benchmark<\/strong><\/span><\/p>\n

Profitable investment management firms all have one thing in common: assets under management (AUM) scale. There are two ways to grow an asset management firm: one short-term and easy, and one long-term and difficult. They are, respectively, successful marketing and successful investing.<\/span><\/p>\n

In the beginning of an asset management firm\u2019s life cycle, AUM is very difficult to acquire. Without quality returns there is not much to market to prospective investors. Consequently, in the beginning, firms \u2014\u00a0often founded by quality investment managers \u2014 focus on generating outsized returns relative to their competition.<\/span><\/p>\n

But then what happens? Inevitably the firm begins to think to itself, “With these returns in hand, we can now gather assets by telling the world our good news story. Scale is now possible. So, too, is that lustrous paycheck we all work so hard to earn.” Enter those adjuncts to the business that aid our growth through marketing. Exit growing AUM by earning the returns.<\/span><\/p>\n

Unless an investment manager is careful at this stage, the focus of the successful investment management firm shifts to pleasing adjuncts to the investment management business \u2014 private wealth managers, registered representatives, and consultants among them \u2013 rather than its clients. But initially what everyone wanted from an investment manager\u2019s performance was similar:<\/span><\/p>\n