Thursday, July 1, 2010

Wrong index or active management?

I taught our Introduction to Performance Measurement course yesterday and one student asked how one might know whether, if the tracking error is high, it is because of (a) active management or (b) the wrong index being used?

I don't believe there's a simple way of knowing this. If the tracking error is exceptionally high (e.g., 15%), then the manger either obliterated the index or is doing something entirely different. So perhaps some levels make it clear that it's probably the wrong index. Style analysis could be a tool that can be used to analyze the portfolio and see if it aligns with the index, at least to some extent. A review of the holdings, sectors, market caps may also be in order. If it's a blended index, does the blend include all sectors in which the manager is investing?

We occasionally see managers use broad indexes, such as the S&P500, when their strategy involves a single style (e.g., growth) or market cap (e.g., mid cap). In this case, it's pretty clear that we have the wrong index.

If you have ideas about this, please chime in. Thanks!

4 comments:

  1. Stephen Campisi, Intuitive Performance SolutionsJuly 2, 2010 at 8:50 AM

    I think that you are exactly right in suggesting that a thorough style analysis is required to determine the source of tracking error. And I think it's a useful insight that you provide in distinguishing the possible source of tracking error being something other than active management. It is often the case that tracking error is caused by 3 factors: a) permanent style differences from the benchmark, and/or b) tactical style differences (a sort of "allocation" effect) and finally c) individual issue selections and trading. A typical style analysis is quite limited because it only finds a permanent allocation to market segments that produce an index that is highly correlated to the manager's performance. It does not distinguish between long term and short term allocation and style differences. (I had proposed a method of using both long term and short term style analysis to make this important distinction between these two manager decisions in an article published in the Journal of Performance: "Long Term Risk Adjusted Performance." I'm reminded that Carl Bacon noted correctly that this might have been better titled "Long Term STYLE Adjusted Performance.) In the article we break out the tracking error and "allocate" it long term structural differences, tactical differences and active management within the "stock picking" dimension.

    There is also value in understanding the PATTERN of the tracking error, because not all tracking error is bad. We know that tracking error simply means that the manager is making active decisions and that these decisions are the source of the risk-adjusted alpha we seek. As an example, consider a manager with a superior "upside/downside" capture ratio. This manager will lose money less frequently than the benchmark, and will experience losses that are less severe. Frankly, I'll take that type of tracking error all day - "back up the truck" - because this is a source of BOTH higher returns and a greater ability to preserve capital, especially for portfolios that are spending money regularly.

    I believe that it is relatively simple to both know the sources of tracking error and whether the tracking error forms a favorable volatility pattern relative to the benchmark. It does require some effort and some insight, but that's part of the value added by experienced and knowledgeable performance staff.

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  2. Thanks for your comments and additional insights!

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  3. Thanks! A bit surprised more haven't commented, though Steve Campisi shared a great deal of wisdom.

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