Performance Evaluation, Benchmarks, and Attribution Analysis

Foreword The measurement of portfolio and manager performance is an integral part of the portfolio management process. Measurement is the way investors and investment managers decide if the strategy they developed and the actions they took have led to the attainment of investor objectives. It is the ultimate feedback investors and managers use to decide if their management of the portfolio needs to be changed. A great deal of solid, high-quality work is being done in the development of practical tools for performance measurement, including the measurement of global portfolio performance. So, we are particularly pleased to be presenting this proceedings at this time. The speakers come from all parts of the industry, and they offer readers analyses of numerous current approaches and concepts. The speakers also address the aspects of performance measurement that are the subject of much debate. Aspects such as the appropriateness of benchmarks (particularly the use of manager universes), the identification of what decisions and what actions caused what effects in the portfolio's performance, and the role of quantitative performance evaluation in manager-client relationships are examples. Another area of debate is the proper presentation of performance results. This issue has always been a major concern for AIMR, and since 1987 when work began on the Performance Presentation Standards, we have held a number of programs devoted to both performance measurement and its presentation. This proceedings contains a summary of issues in presentation that have recently been resolved and issues currently under review. In addition, we are pleased to include perspectives on the PPS presented by speakers from the client and manager sides. In-

formation for ordering AIMR's Performance Presentation Standards, 1993 is given at the end of this proceedings. We wish to extend special thanks to Edward P. Rennie, CFA, of Pacific Investment Management Company, who spoke about firm adoption of the PPS and served very ably as the moderator of the seminar. In addition, we are grateful to Jan R. Squires, CFA, of Southwest Missouri State University, for his help in editing this volume and preparing the Overview. He has been a staunch, dedicated supporter of AIMR and the process of continuing education. Finally, we wish to thank all the speakers for their insights and assistance: Keith P. Ambachtsheer, KP.A. Advisory Services; Gordon M. Bagot, The WM Company; Jeffery V. Bailey, CFA, Richards & Tierney; Peter L. Bernstein, Peter L. Bernstein; Charles B. Burkhart, Jr., Investment Counseling; Michael S. Caccese, AIMR; Thomas J. Cowhey, CFA, Bell Atlantic Corporation; J. Paul Dokas, CFA, Bell Atlantic Corporation; D. Don Ezra, Frank Russell Company; Michael J. Flynn, Stratford Advisory Group; Philip Halpern, The Washington State Investment Board; Jack L. Hansen, CFA, The Clifton Group; Robert C. Kuberek, Wilshire Associates; Patricia K Lipton, State of Wisconsin Investment Board; Christopher G. Luck, BARRA; Scott L. Lummer, CFA, Ibbotson Associates; John P. Meier, CFA, Strategic Investment Solutions; Brian D. Singer, CFA, Brinson Partners; Lawrence S. Speidell, CFA, Nicholas-Applegate; Donald W. Trotter, CFA, Atlantic Asset Management Partners; Reza Vishkai, RogersCasey; and Craig B. Wainscott, CFA, Frank Russell Company.

Katrina F. Sherrerd, CFA Senior Vice President Education

vii

Performance Evaluation: An Overview Jan R. Squires, CFA Professor ofRnance Southwest Missouri State University The evaluation of investment managers' performpensated, and fired are important elements in the overall evaluation picture. ance-always a major concern of investment management firms, consultants, sponsors, and The speakers who address these questions come clients-becomes increasingly difficult in today's from nearly all facets of the investment industrycomplex investment environment. The sophistication portfolio management, research, investment analyof markets, instruments, and investment professionsis, and consulting. They discuss an impressive variety of performance topics, from domestic and als; the proliferation of both performance-related data and techniques to analyze those data; and the global benchmarks to implications of investment worldwide increase in potential sources of positive styles, attribution analysis for nontraditional asset performance-all fuel the suspicion that yesterday's programs, and the role of manager universes. The common themes throughout are the unquestioned performance yardsticks may not be appropriate for the challenges of today and tomorrow. These very importance of performance evaluation, the need to factors, ironically, raise the level of competitiveness think critically and carefully about its implementaamong investment managers and reduce opportunition, and the desire to serve clients best by "getting ties for the"easy" achievement of added value. The it right." result is that meaningful performance evaluation is all the more important at the same time that it has - - - - - - - - - - - - - - - - - - - - - become all the more difficult. Benchmark selection In such a high-stakes environment, a fresh look Both equity and fixed-income indexes, whether doat performance evaluation may enable all particimestic, global (inclusive of domestic assets), or interpants in the evaluation process, from the managers national (exclusive of domestic assets), are used for being evaluated to the clients whose welfare is being a variety of purposes, from benchmarking to reserved, to sharpen their understanding of and test search and asset allocation. Scott Lummer addresses their assumptions about the nature of performance several issues that arise in the use of U.S. equity and its measurement. This proceedings is the prodindexes. He contends that capitalization size best uct of an AIMR seminar intended to give participants explains differing levels of stock performance; the just such a renewed perspective on the key ingredichoice between value and growth and the choice of ents of meaningful performance evaluation: index provider are less important factors and should • Which benchmark is most appropriate for evaluatbe so recognized-by clients and managers. John ing a particular manager's performance? A rapidly Meier, describing and comparing the equity indexes growing set of domestic and global benchmarks, for developed and emerging markets, examines hiscoupled with an infinite variety of customized torical returns, volatility, and correlations. The major benchmarks, makes benchmark selection an espenon-U.s. equity indexes exhibit only minor differcially complicated task. ences, but they may not be particularly good proxies, • What are the major contributing factors to a manMeier suggests, for what many global managers are ager's apparent performance? The isolation and meastrying to achieve. As a result, clients and managers urement of the many potential sources of may find advantages in using the regional indexes performance, particularly in a global setting, is a and/or specifically customized global equity benchconstant challenge, and the quest for a proper attrimarks. bution model is ongoing. Donald Trotter reviews the most commonly ac• How should performance results be presented? cepted U.S. fixed-income benchmark providers and The best benchmark decisions and the most sophisproposes guidelines for evaluating their products. ticated attribution models are of little use if perHe argues that index composition is more important formance results are not comparable across a than construction methodology or provider and that variety of managers. many sponsors and clients would be well served by • How should important manager relationships be a customized fixed-income benchmark. Reza Vishkai reflected in, or reflective of, performance evaluation? compares the four major worldwide fixed-income The processes by which managers are hired, comindexes in terms of standard index characteristics. 1

He finds no compelling reason to choose one index over another; rather, the benchmark choice should reflect the investor's unique specifications and constraints. Benchmark selection must also reflect an increasingly global but, at the same time, segmented investment environment. Christopher Luck discusses several issues involved in standard and customized equity benchmarks. In particular, he emphasizes the importance of investment style, the availability of style applications, and the importance of benchmarks reflecting a manager's long-term style bias. Philip Halpern notes that international portfolios pose important challenges for those choosing or developing benchmarks, and he questions whether any of the standard benchmarks are useful proxies in today's investment world. Lawrence Speidell explores whether markets around the world are becoming more homogenous internally and whether they are drawing closer together externally. His findings indicate that the answer to both questions is no: First, small-capitalization stocks are singularly different in nearly all markets, and second, intermarket correlations actually decline in the absence of severe global "shocks." The decisions in benchmark selection, in summary, need to recognize and incorporate the manager's unique strategy and the global market inefficiencies and high global trading costs suggested by research findings.

Attribution Analysis

classes; in the latter, he introduces a Manager Model to test for manager skill. Brian Singer and Gordon Bagot present analyses of the usefulness and drawbacks of attribution analysis specifically in the global context. Singer argues that attribution analysis-especially for global portfolios but also for domestic portfolios-should reflect only those processes and parameters that the manager can control and manage, He elaborates a framework for global attribution analysis that takes into account both currency and market considerations. Bagot provides an overview of the development of performance measurement for global portfolios that highlights current issues and problems in attribution analysis. He joins other speakers in emphasizing that only attribution that recognizes the subtleties of the investment context and the manager's own decisions and constraints is valuable. Jack Hansen discusses the importance of performance measurement for nontraditional assets and establishes a framework for such measurement. That framework focuses on the investment decision, the implementation vehicle, and the selection of the manager or managers most likely to add value in implementing the decision. Michael Flynn and Jeffery Bailey confront the controversial issue of manager universes. Flynn outlines what clients should know in using manager universes and peer groups as effective measurement tools. Unfortunately, he notes, much of the needed information is not readily available. Accordingly, he argues that these tools should be used only in conjunction with other, potentially more reliable tools, such as customized benchmarks or indexes. Bailey presents a critical examination of manager universes detailing four serious problems that compromise their usefulness as measurement tools. He contends that these problems are largely insurmountable and recommends that sponsors and managers devote their attention to developing improved customized benchmarks with well-defined quality characteristics.

Whether its objective is traditional-to measure value added by managers-or more ambitious-to quantify manager skill-attribution analysis is an important facet of the performance measurement process. Peter Bernstein sets the stage for a detailed exploration of attribution analysis by contributing a lively look at the foibles of performance measurement and the false hopes it may raise. Questionable bogeys, uncertain excess returns, inadequate distinctions between luck and skill-these and other issues should keep investment professionals humble as they go about the performance evaluation process. Performance Presentation Focusing on equity attribution, Craig Wainscott points out both the useful and the troublesome asDevelopment of the Performance Presentation pects of performance attribution. If it reflects the Standards (PPS) by AIMR has provided the impetus manager's actual decisions, attribution analysis can for investment organizations and professionals around the world to rethink what clients need in link positive investment results to those decisions order to make performance judgments over time and and provide the client with a basis for ascribing such among managers. Michael Caccese reviews the inresults to the manager's skill. Analyzing fixed-income attribution analysis, Robert Kuberek details creasing industry acceptance of and regulatory intertwo important aspects: the decomposition of manest in the PPS. He also identifies a number of agement return and the assessment of value. In the initiatives that are under way to address still unreformer, he argues for the use of subindex weights as solved issues, such as verification of compliance and the nature of composites. Paul Dokas presents the well as risk factors in describing fixed-income asset 2

views of a plan sponsor that has endorsed and supported the PPS. He believes that, although refinements are needed in the use of composites and the treatment of nontraditional assets, the standards have enhanced and improved the investment industry. Edward Rennie presents an investment manager's view of the PPS. He notes, in particular, that the standards are entirely consistent with his firm's client-service objectives of proactivity and full disclosure.

Manager Relationships To be useful, a performance measurement paradigm must reflect, and be reflected in, the processes through which client-manager relationships are defined-in particular, manager compensation, evaluation, and hiring and firing. Charles Burkhart details several measures of investment firm performance within the context of trends in the investment industry. Especially noteworthy is the comparison and contrast of operating characteristics and compensation levels of U.S. and Canadian firms. Thomas Cowhey sets forth an approach for

evaluating plan sponsors' management of their overall pension funds. The approach enables fiduciaries to focus on plan performance relative to the plan's policy portfolio, appropriate benchmarks, and the relevant costs incurred. Keith Ambachtsheer offers a critical exploration of the nature of the investment management services industry and the elements of a sound manager search strategy. His continuing interest in the economics of investment management is evident in his contrasting of inductive and deductive approaches to hiring and firing managers. Patricia Lipton outlines the process used by the State of Wisconsin Investment Board (SWIB) in conducting a manager search. SWIB requests a variety of performance information from managers, and SWIB's extensive analysis of that information often raises important warning signals about managers and their performance. The final presentation is a thought-provoking look provided by Don Ezra at the best use of a limited budget for manager fees. Both his discussion and the research findings he presents affirm the importance, and costeffectiveness, of active management.

3

u.s. Equity Indexes as Benchmarks Scott L Lummer, CFA Managing Director Ibbotson Associates

In using U.s. equity indexes, especially for benchmarking, clients and managers alike must deal with several key issues. Capitalization size appears to be the most substantial factor in systematically differentiating stock index performance; this factor is followed by the proportions of value and growth stocks. No single index may have the appropriate capitalization and value-growth mix needed to serve as a benchmark for a particular portfolio. Thus, a customized benchmark may be preferable.

Think about how analysts and investors use indexes. Sometimes they use them for research, and on the basis of that research, they frequently make asset allocation decisions. Sometimes they use them for benchmarking. Investors' attitudes toward indexes depend somewhat on the type of investors they are and their personalities. Those who do not worry about details are not focused on analyzing the indexes they use; those who are detail oriented believe that analyzing the various indexes, particularly for use as benchmarks, is very important. This presentation compares the major U.S. equity indexes and discusses how they can be best used in benchmarking. The two aspects of an index that are most important in judging its suitability as a benchmark for a particular portfolio are, first, capitalization and, second, mix of value and growth stocks.

Capitalization The first necessity for using equity indexes for performance measurement and analysis is to pinpoint the capitalization of the stocks in the index. Table 1 contains calculations of long-term U.S. equity returns and risks (volatilities) for deciles of NYSE stocks based on capitalization. The data used for the table are Center for Research in Security Prices (CRSP) data that go back to 1926 and break down equities into ten deciles-with Decile 1 being the 10 percent of stocks with the largest capitalization and Decile 10 being the 10 percent with the smallest. The figures reported are geometric averages for the period. The definitions of large-cap, small-cap, midcap, and so on are not entirely consistent in the industry, but Table 1 indicates how standard indus4

try definitions would likely be applied to the deciles. Table 1 underlines the importance of capitalization for volatility and return. The differences between the largest-cap figures and the smallest-cap figures is huge. The difference in returns is 450 basis points (bps), and Decile 10 volatility is almost 2.5 times Decile 1 volatility. Thus, how a manager will perform in relation to an index will depend significantly on whether the capitalization ranges in the index match those of the manager's portfolio. Figure 1 graphs the historical performance, $1.00 invested at year-end 1925, by standard capitalization category. The smallest-cap decile clearly has a return well above that of the others, but when you look at downs in the market, it also has the biggest fall. The movements of the decile groups are not perfectly correlated; as Figure 2 shows, at times (in this case, the 1984-91 period), some deciles move up and down over a time period while the returns for other deciles are more consistent. Table 2 clarifies these different patterns. Returns are dramatically and consistently different as the deciles go from large cap to small cap. What is interesting is that the groups had almost identical volatility in this period. The result was a small-cap bear market; small caps performed terribly relative to large caps, and the smallest-cap decile did the worst. The patterns for the groups in a bull market for small caps are shown in Figure 3, and the results for the period are given in Table 3. The period is the three and a half years up through June 1994. Some exceptions in the relative patterns occur in such short time periods; Decile 9 is one example. During this period, in general, the smaller the capitalization, the higher the returns.

Table 1. Long-Term U.S. Equity Returns and Volatilities by Capitalization Deciles, 1926-94 Decile Decile 1 (very large cap) Decile 2 (somewhat large cap) Deciles 3-5 (mid cap) Deciles 6-8 (small cap) Decile 9 (micro cap) Decile 10 (quark cap)

Table 2. Returns and Volatilities by Capitalization Deciles, 1984-90

Compounded Return

Volatility

9.3% 10.7 11.4 11.7 12.0 13.8

20.0% 24.2 26.8 31.8 39.6 49.4

Decile

Compounded Return

Decile 1 Decile 2 Deciles 3-5 Deciles 6-8 Decile 9 Decile 10

Volatility

15.2% 14.2 11.6 7.6 1.8 -7.4

19.2% 21.0 20.7 22.0 20.8 20.1

Source: Ibbotson Associates.

Source: Ibbotson Associates.

of the large-cap universe (Decile 2). The important lesson is that deciles have significantly different returns during different time periods. So, capitalization does make a difference in The Indexes performance and performance measurement. This Pure decile data provide better yardsticks of perlesson raises two issues for investors. First, is the by cap size than do indexes because the formance "large-cap" manager really large cap? If not, a true compilation of indexes requires judgments about large-cap index will be the wrong benchmark for that what to include and what to exclude. In addition, the manager. Second, how large cap is the manager; that decile data go all the way back to 1926, whereas the is, how much small cap and mid cap is in the largeu.s. equity indexes go back only to the 1970s; so, cap portfolio? This mix makes a difference to evaluusing decile data directly allows comparison of veryations of manager performance. For instance, in a long-term performance. market like that depicted in Figure 3, a large-cap Although capitalization is important, which curmanager who stuck solely with the very largest rent large-cap index the fund uses is not important. stocks (Decile 1) would be expected to have a 500-bp As Table 4 shows, the three classic indexes for largelower return for the past three and a half years than cap U.s. equities are all highly correlated with each other and with the two largest-cap deciles of the a large-cap manager who stuck with the bottom half Figure 1. Total Returns by Deciles, 1926-94 Year-End 1925= $1.00 $10,000

$1,000

$100

$10

$1

$0 26

86

- - NYSE Decile 1

---. . . . NYSE Deciles 3-5

NYSE Decile 9

• • • NYSE Decile 2

- - - NYSE Deciles 6-8

NYSE Decile 10

91

96

Source: Ibbotson Associates.

5

Figure 2. Total Returns by Deciles, 1984-91 Year-End 1983= $1.00 $5

$4

$3

$2

$1

$0 84

85

86

87

89

88

90

NYSE Decile 1

NYSE Deciles 3-5

NYSE Decile 9

NYSE Decile 2

NYSE Deciles 6-8

NYSE Decile 10

91

Source: Ibbotson Associates.

Figure 3. Total Returns by Deciles, 1991-94 Year-End 1990= $3.00 $3

$2

$1

[ I 1/91 4/91 7/91 10/91

NYSE Decile 1

NYSE Deciles 3-5

NYSE Decile 9

NYSE Decile 2

NYSE Deciles 6-8

NYSE Decile 10

Source: Ibbotson Associates.

6

[

1/92 4/92 7/92 10/92 1/93 4/93 7/93 10/93 1/94 4/94

7/94

Table 3. Returns and Volatilities by Capitalization Deciles, 1991~une 1994 Compounded Return

Decile

Volatility

10.1% 15.5 18.7 20.0 19.4 27.2

Decile 1 Decile 2 Deciles 3-5 Deciles 6-8 Decile 9 Decile 10

11.6% 12.7 13.6 14.9 19.1 33.9

Source: Ibbotson Associates.

market. Table 5 shows that during the longest period of time when all of these indexes were in use-13 1;2 years-the difference in returns from highest to lowest was a mere 60 bps. The S&P 500 and the Russell 1000 indexes have slightly higher returns than Deciles 1 and 2, which is predictable because all three indexes dip outside of Deciles 1 and 2 to some extent.

Table 6. Correlations between Mid-eap Indexes, 1981~

Index

Deciles 3-5

S&P400

Wilshire Mid-Cap

1.00 .97 .99

1.00 .98

1.00

Deciles 3-5 S&P400 Wilshire Mid-Cap

Source: Ibbotson Associates.

fairly high correlations but not 1.00. Does that imperfect correlation make a difference? Examining the returns to the mid-cap indexes, given in Table 7, shows that imperfect correlation does make a difference. The Wilshire Mid-Cap returns have been quite a bit lower than those of the Table 7. Performance of Mid-eap Indexes, 1981~ Index

Table 4. Correlations between Large-Cap Indexes, 1981~

Index Deciles 1 and 2 S&P 500 Wilshire Large-Cap Russell IOOO

Deciles 1 and 2 1.00 1.00 1.00 1.00

Wilshire S&P 500 Large-Cap 1.00 1.00 1.00

1.00 1.00

Russell IOOO

1.00

Source: Ibbotson Associates.

The returns from the Wilshire Large-Cap Index are somewhat surprising, although they may result because the time period included the small-cap bear market of 1984 through 1990. The indexes have almost identical volatilities, and higher volatilities than the top two deciles.

Compounded Return

Volatility

15.1% 16.1 13.6

18.8% 19.0 19.6

Deciles 3-5 S&P400 Wilshire Mid-Cap

Source: Ibbotson Associates.

S&P 400 and Deciles 3-5 but with a little more volatility. The probable reason is that the compilers of the Wilshire Mid-Cap are including lower-capitalization stocks than the compilers of the S&P 400. The differences thus illustrate the effects of judgments in compiling indexes. The small-cap indexes, as Table 8 indicates, are almost as highly correlated with each other and their appropriate decile group as are the large-cap inTable 8. Correlations between Small-eap Indexes, 1981~

Table 5. Performance of Large-Cap Indexes, 1981~ Index

Compounded Return

Volatility

13.0% 13.5 12.9 13.1

16.8% 17.3 17.2 17.3

Deciles 1 and 2 S&P500 Wilshire Large-Cap Russell 1000

Index Deciles 6-8 Wilshire Small-Cap Russell 2000

Deciles 6-8 1.00 .99 .99

Wilshire Small-Cap

Russell 2000

1.00 .99

1.00

Source: Ibbotson Associates.

Source: Ibbotson Associates.

Disciples of one index or another among invest-. ment professionals devote a great deal of debate to differences among the large-cap indexes. Considering the minor differences shown here, this debate appears to be much ado about nothing. True differences show up in the mid-cap indexes. Table 6 shows correlations between the two major mid-cap indexes, the S&P 400 and the Wilshire Mid-eap, and the group of Deciles 3-5. They have

dexes. Returns, at least for this short time period, reflect some differences, as shown in Table 9. The Wilshire Small-Cap Index and the Russell 2000 Index dipped into lower deciles than Deciles 6-8, and in this market, the smallest of the small-cap performed poorly. The choice of small-cap index might not make a difference in the long term, but it might in the short term. The small-cap U.s. equity indexes have a short history, and compositions may change from time to 7

Table 9. Performance of Small-eap Indexes, 1981-94 Compounded Return

Index Deciles 6-8 Wilshire Small-Cap Russell 2000

Volatility

14.2% 13.2 11.5

20.4% 20.3 21.3

Source: Ibbotson Associates.

time in the future. Determining which is the correct index to use is thus difficult.

Choosing a Benchmark by Capitalization

Table 11. Small-eap Returns

One way for an investor to determine which index is the correct one to use as a benchmark is to analyze the correlations between the fund and the various possible indexes. Table 10 gives the correlations of four mutual funds classified as growth and income funds by both Morningstar and Lipper Analytical TClbie 10. Correlations between Funds and Benchmarks, 1988-94 Fund Maxus Mutual Beacon Windsor Mainstay Value

S&P 500

Wilshire 5000

Russell 3000

Customized Benchmark

.71 .77 .85 .86

.77 .82 .87 .89

.76 .80 .86 .89

.89 .87 .89 .91

Source: Ibbotson Associates.

ized benchmarks are compared with the performance of the Wilshire 5000 Index during the recent small-cap bull and bear markets in Table 11. (We performed a similar analysis comparing the S&P 500 and the Russell 3000 with similar results.) Note that the customized benchmarks' returns are much closer to the returns of the four funds than are the returns of the index. The most dramatic difference for the small-cap bull market is for the Mainstay Value Fund, and the second most dramatic is for the Maxus Fund.

Benchmark/Fund

Small-Cap Bear Market (1988-90)

Small-Cap Bull Market (1991-94)

12.6%a

13.4%

11.6 10.7

18.8 15.5

7.8 10.1

18.7 15.4

9.8 10.3

20.5 15.9

-8.4 -13.0

19.6 18.0

Wilshire Small-Cap Mutual Beacon Fund Customized benchmark Windsor Fund Customized benchmark Mainstay Value Fund Customized benchmark Maxus a Fund Customized benchmark

aReturns for the Maxus Fund in the bear market are only for a short subperiod; the Wilshire Small-Cap Index return for the same subperiod is -2.4 percent.

Source: Ibbotson Associates.

Services with the three large-cap indexes and a customized benchmark for the 1988-94 period. Most of The reason the customized benchmarks work so the large-cap growth and income funds Ibbotson well is the small-cap exposure in the four funds. Associates examined had a correlation of at least .9 Because all of these funds had some exposure to with the large-cap indexes. These four funds were small-cap stocks, they all underperformed the Wilthe exceptions, and we wanted to know why. shire 5000 in the small-cap bear market. The customThe customized benchmark we built is much ized benchmarks come much closer than that more naively customized than what a fund would standard benchmark to describing the funds' peractually do. We first determined what proportion of formances and to differentiating their performances. large-cap and small-cap stocks composed each of the four funds. Some funds had much heavier small-cap exposure than others, and some had much heavier Value versus Growth large-cap exposure. The benchmark for each fund After capitalization, the second most important facconsists of the large-cap and small-cap indexes in tor in systematically differentiating stock performthose proportions. ance is whether the stock is growth stock or value In all cases, the customized benchmark raises the stock. Therefore, the three major providers of US. correlation, and in a couple of cases, it raises it draequity indexes all compile subindexes classified as matically. What is the conclusion? Bear in mind that growth or value. Panel A of Table 12 contains returns the benchmark should never predict an individual and volatilities for the six indexes for periods ranging fund perfectly; that would take all the usefulness out from 16 to 19 years (based on when various indexes of the benchmark. But knowing that a simple split were begun). Some growth indexes experienced betbetween large-cap and small-cap composition will ter performance than others, but for the entire time tell you something about the performance of a fund period, growth indexes underperformed value inis fairly useful. dexes. The performances of the funds and their customPanel B of Table 12 uses the S&P-BARRA value 8

Table 12. Returns from Large-Cap Value and Growth Indexes Index

Years

A. Long-term returns 1975-94 S&P SOD-BARRA Value Growth 1978-94 Wilshire 5000 Value Growth 1979-94 Russell 3000 Value Growth

Return

Volatility

16.3% 12.8

16.8% 18.9

15.6 14.3

15.8 20.1

15.6 13.8

16.6 19.8

12.6 15.2

15.2 17.5

13.7 10.4

11.8 13.6

stocks in a manager's portfolio makes a difference in choosing a benchmark for the portfolio. Even if their portfolios are intended to be a blend of value and growth, most managers do have a tilt toward either growth or value. And they tend not to change that tilt much in different time periods; if they have tended toward three-quarters value in the past, they will tend to remain around that point in future markets. For measuring a manager that is tilting one way or another, the fund needs a customized benchmark built on a value-growth basis instead of a broad S&P 500, Wilshire 5000, or Russell 3000 index.

B. Most recent short-term returns S&P 500-BARRA Value Growth S&P SOD-BARRA Value Growth

1988-90

Conclusion

1991-94

Source: Ibbotson Associates.

and growth subindexes to illustrate the patterns of returns and volatilities for the 1988-90 and 1991-94 periods. The 1988-90 period was a bullish market for growth stocks, and the later period was bullish for value. The earlier period was a bad market for small caps in general but good for growth stocks within the small-cap sector and the large-cap sector. Therefore, the balance of growth and value

Differences among the available U.s. equity indexes are minor, and no one index may have the appropriate capitalization and value-growth mixes to be suitable as a benchmark for a particular portfolio. Therefore, customized benchmarks may be preferable. The process of customizing benchmarks requires sponsors to learn about managers' preferred capitalization mix and value-growth tilt. Customized benchmarks based on those factors, in turn, allow sponsors to track and judge performance better than does using the available indexes.

9

Question and Answer Session Scott L. Lummer, CFA Question: Are there generally accepted definitions of large cap, mid cap, and small cap by the index providers or in your translation, as in Table 1, of the deciles into general capitalization terms? Lummer: In all the US. equity indexes, standards for capitalization depend on overall market capitalization. Instead of actual capitalization numbers, the indexes use a specific number or proportion of stocks in the universe to create an index. So, what large cap is, for example, changes from time to time. The capitalization breakpoint is a lot higher now than in 1980, and the breaks between small and mid and large depend on the particular index. We prefer to use the decile data because it has ten breakpoints rather than the usual three-mid cap, large cap, and small cap. I can give you some general definitions for the decile groups. For example, micro cap would be around $150 million market capitalization. Question: How often are the deciles of capitalization recalculated? Lummer: CRSP reweights its indexes every year based on market capitalization. Without rebalancing, you tend to get some drift in an index. Managers do not dump a stock just because it has moved from small cap to large cap, of course. They rebalance sometimes when they stop following that stock and certainly when they sell that stock. At that point, they do not buy a similar cap stock; they will go back to their preferred habitat in the stock universe.

10

Question: Are value and growth properly defined by the various indexes? Lummer: The definitions are somewhat subjective. The S&P 500-BARRA Index has simple definitions of value and growth based solely on P /E. I would prefer the ratio of price to book value (P/B) because it is much more stable than P/E; stocks leave and enter the index much less frequently if a stable measure such as P /B is used. We take what the three providers give us, however; we don't want to inspire yet another company to provide indexes. Question: How do you customize a benchmark by small cap and large cap for a manager who is continuously changing the balance of the portfolio? Lummer: To pick a benchmark that is appropriate to that manager, you need very-long-term data just to see where the manager tends to be. For instance, if the manager's tendency is toward 60 percent large cap and 40 percent small cap, then that will be your customized benchmark. The manager is behaving as a sector rotator in the equity market, so defining the average combination of sectors (in this case, large cap and small cap) is very important for measuring performance correctly. You also have to recognize that the manager is not going to track any benchmark as closely as a manager who does not move the portfolio around much. The customized benchmark is useful, nevertheless, because part of a manager's job is to rotate his or her style. If the manager is 60/40

large/small cap on average but moves more toward the small-cap sector during some period, you would reward or penalize the manager for making that decision depending on how things work out. We have found that most managers do not change the proportions of large- and small-cap sectors much. For them, a customized benchmark is relatively easy to calculate and allows you to examine what they are really doing, which is picking specific stocks to deviate from the index within each of the large-cap and smallcap sectors. Question: If a manager changes from a style that the manager initially stated would be followed, how do you measure this manager? Lummer: If a change in investment policy causes a manager to change proportions of large and small or growth and value in the portfolio, we would immediately change the customized benchmark. Keep in mind, however, that we often customize benchmarks not according to what managers say they will do but according to what the managers are actually doing. Many smallcap managers are trapped in the bodies of large-cap managers; they may say they are large-cap managers, but they look a lot like small-cap managers in terms of returns, composition of portfolios, and volatilities. If a manager announced a change in policy in 1992, we would be looking at the returns and volatilities three years later to see if the policy actually changed.

Non-U.S. Equity Indexes John P. Meier, CFA Director of Quantitative Consulting Strategic Investment Solutions, Inc.

Few differences mark the world or developed market equity indexes, but equity investors in emerging markets should choose carefully between the investable indexes and the global, capitalization-weighted indexes that are currently available. The development of combined and/or customized equity indexes is accelerating to address the difficulties investors confront in finding suitable benchmarks for particular international investment strategies.

With the rapid growth in global equity investing during the past several decades and the emergence of varied global equity asset classes, non-U.s. equity indexes have become increasingly important in asset allocation and performance measurement. Current non-U.S. equity indexes can be compared on the basis of how the different indexes are constructed and other characteristics, the most important of which is the country weights. This presentation will describe and compare developed market and emerging market indexes and describe subindexes and combined indexes that are available. The overview will examine historical returns, historical volatility, and historical correlations between assorted indexes. Because portfolio managers and clients want to know how similar or different these indexes will be in the future (not merely what the past characteristics have been), forecasts of future index risks and correlations are presented.

Index Construction Of the three major international market index providers, Morgan Stanley Capital International (MSCI), which has been providing indexes for the longest time (since about 1970), is the index most often used by people in the U.s. investment community. The second is the Financial Times Actuaries (FT) Index (devised by a consortium of the Financial Times, Goldman, Sachs & Company, and NatWest Securities), which has existed since 1987. The third provider is Salomon Brothers, which formerly produced international indexes jointly with Frank Russell Company. In addition to these major providers, the International Finance Corporation and Bar-

ing Securities produce emerging market indexes and Goldman, Sachs produces a combined developed and emerging market index.

Developed Market Indexes The developed market indexes of the three providers can be compared by capitalization coverage, industry and country coverage, and asset restrictions. As for capitalization coverage, MSCI currently tries to capture 60 percent of market capitalization in its developed market indexes, the FT covers 85 percent of the investable universe, and the Salomon, which aims for full coverage, encompasses 95 percent of total market capitalization. In their industry coverage, the MSCI and FT indexes attempt to replicate the market; Salomon Brothers states that it has no industry constraints, which effectively results in market replication. In their coverage of the developed countries, the FT has 26 countries and the Salomon has 22; the MSCI currently has 22 countries plus South African gold. The biggest differences among the developed market indexes occur in asset restrictions and in the resulting asset coverages. All exclude nondomestic securities and funds, but the FT and Salomon indexes differentiate themselves by including only assets available to nondomestic investors; in this way, they try to capture the opportunity set that is available to an international investor. The MSCI indexes use a sample of large, medium, and small assets, while taking the stocks' liquidity into account. MSCI also avoids restricted shares and those with limited float. The FT indexes restrict assets to those with at least 25 percent free float (which are included at full capitalization) and 11

the FT Europe and Pacific (EurPac) Index, and three subsets of the Salomon Europe and Pacific (EPAC) Index-the EPAC Broad Market Index (BMI), the EPAC Primary Market Index (PMI), and the EPAC Extended Market Index (EMI). The MSCI EAFE, FT EurPac, and the Salomon EPAC BMI have almost the same country coverages and country weights. Because of the float-based construction rules of the Salomon indexes, one might expect Japan to be substantially underweighted in the EPAC, but in fact, it is not. In short, despite some different characteristics and construction rules, if country coverage basically drives the performance of an index, these indexes will have similar performance. The big difference is between the MSCI EAFE CDP-Weighted Index and the other developed market indexes. Conceptually, a CDP-weighted index is an economically justifiable way of underweighting Japan in a benchmark. When investors indicated an unwillingness to place from 40 percent to as much as 60 percent of a portfolio in Japan, CDP weighting in an international benchmark was developed as an alternative approach. Now, CDP-weighted indexes are offered by all the major index providers.

exclude the bottom 5 percent in capitalization; in addition, to be included in the FT indexes, assets must have traded 15 days in each of the preceding two quarters. The Salomon developed market indexes exclude assets of firms with less than US$100 million in capitalization. In addition, instead of looking at total capitalization when including assets, Salomon concentrates on float capitalization. In markets with many cross-holdings, such as Japan, that restriction makes a big difference. The Salomon approach is based on the question: If an investor were trying to buy the entire market, how much would the investor have to invest? Because of the many cross-holdings, an investor would not have to buy the full market capitalization of every issue. One result of this approach is that the Salomon indexes are float/cap weighted, whereas the MSCI indexes are cap weighted and the FT indexes are investable/cap weighted. The MSCI World Index includes about 1,600 assets; the FT World Index, about 2,200; and the Salomon World Index, 6,500. The Salomon World Index is so large primarily because it is trying to include the bottom 30 percent in capitalization-the capitalization range that contains most assets. The specific equity benchmarks that people use most often for investing in the non-North American developed markets are quite similar in country coverage. Table 1 shows the country coverages, by percentage weights, of the MSCI Europe/ Australia/Far East (EAFE) and the EAFE CDP-Weighted indexes,

Emerging Market Indexes As with the developed markets, three organizations provide the major emerging market indexes. The International Finance Corporation (IFC) was the only provider of these indexes until Baring Securities and MSCI began publishing indexes in the early 1990s. Baring tries to differentiate its index by deliberately

Table 1. Developed Market Index Country Weights, June 30, 1994 MSCI

Country

EAFE

Australia 2.6 Austria 0.4 Belgium 1.0 Denmark 0.8 Finland 0.5 France 6.0 Germany 6.2 Hong Kong 3.6 Ireland 0.2 Italy 2.3 46.3 Japan Malaysia 2.2 The Netherlands 3.4 New Zealand 0.4 Norway 0.4 Singapore 1.1 Spain 1.7 Sweden 1.5 Switzerland 4.3 United Kingdom 15.1

Salomon

GDP 2.5 1.5 1.8 1.2 0.8 11.5 14.8 1.0 0.4 8.4 35.0 0.6 2.7 0.4 0.9 0.5 3.9 1.6 2.0 8.4

FT EurPac

BMI

PMI

EMI

2.5 0.2 1.1 0.6 0.4 5.7 5.8 3.6 0.2 2.5 49.1 1.8 3.2 0.3 0.2 0.9 1.7 1.4 3.7 15.4

2.8 0.2 0.8 0.6 0.4 4.8 5.8 3.1 0.2 2.0 47.0 1.4 3.5 0.3 0.2 0.9 1.2 1.4 4.3 19.0

2.8 0.2 0.8 0.6 0.4 4.9 5.8 3.1 0.3 2.0 47.0 1.4 3.5 0.3 0.2 0.9 1.2 1.4 4.4 19.1

2.9 0.2 0.7 0.6 0.4 4.8 5.9 3.1 0.2 2.0 47.1 1.3 3.5 0.3 0.2 0.9 1.2 1.3 4.2 18.6

Source: John P. Meier, based on data from BARRA for the MSCI and FT indexes and from Salomon Brothers.

12

seeking to provide an investable type of emerging market index, which the other two do not stress. Capitalization coverage is about 60 percent for the MSCI and IFC emerging market indexes. Baring does not state that it is trying to capture any degree of market capitalization. As for industry coverage, MSCI attempts to replicate the market for emerging countries and Baring seeks "reasonable sector representation." Emerging market indexes tend to add a new country every month or so; thus, country coverages change rapidly. In mid-1994, as Table 2 shows, the IFC Global Index covered 24 countries, the MSCI Global Index covered 18, and the Baring Index covered 15. The Baring 15 countries and the MSCI 18 countries are subsets of the IFC 24 countries, and the Baring 15 are a subset of the MSCI 18 countries with one exception, Peru. Table 2. Emerging Market Index Country Weights, June 30, 1994 MSCI Country

Global

3.4 Argentina Brazil 9.4 Chile 4.0 1.2 Colombia 1.0 Greece Hungary India 7.0 2.8 Indonesia 0.2 Jordan 12.7 Korea 13.7 Malaysia 13.6 Mexico Nigeria 0.9 Pakistan Peru The Philippines 2.6 Poland 1.1 Portugal Sri Lanka 17.2 Taiwan 7.7 Thailand 1.1 Turkey Venezuela 0.4 Zimbabwe

IFC Free

Global Investable

Baring

4.9 13.3 5.7 1.6 1.4

2.5 8.8 4.0 1.5 0.8 0.1 7.5 2.2 0.3 11.9 14.4 13.4 0.2 0.9 0.4 2.7 0.2 1.1 0.2 16.1 8.6 1.5 0.4 0.1

7.5 17.6 6.1

10.0 4.0 0.2 3.6 19.6 17.4 1.3

2.4 1.5

11.0 1.5 0.5

5.3 12.1 1.9 2.4 1.6 0.1 3.5 2.3 0.2 2.4 24.5 25.1 1.0 0.8 2.7 0.5 1.6 0.1 2.9 5.3 3.2 0.6

1.5

2.1 3.7 14.5 23.4 0.7 1.2 3.1 2.7 7.1 8.0 0.8

Source: John P. Meier, based on data from BARRA for the MSCI indexes, from Baring Securities, and from the IFC.

As with the developed country indexes, the emerging market indexes exclude nondomestic securities and funds, but the emerging market indexes exhibit some differences in other asset restrictions. Each provider uses different country weights, which does make a difference in the return characteristics of the indexes. MSCI has basically the same philosophy for the emerging markets as for the developed markets (a sample of sizes, liquidity considered, re-

stricted and limited-float shares avoided), so if an investor is looking for a combined developed and emerging market index, the MSCI indexes provide a consistent approach. In the MSCI's full emerging market index, if a company has one issue that international investors can buy, MSCI includes all the listed issues for that company no matter whether international investors can actually buy those issues or not. The IFC full index includes only stocks listed on local exchanges, and it covers all classes of stocks regardless of liquidity levels. The Baring index is designed to be an investable index; it includes only companies that have capitalization of more than 1 percent of the Baring emerging markets data base and an average daily trading volume of US$100,OOO. All three providers use capitalization-based weighting schemes for their emerging market indexes. The IFC full index, with 1,270 issues, is the largest, and the IFC is continually increasing the number of issues as it continues to add countries. The MSCI full emerging market index includes approximately 840 issues. The Baring Index, at 288 issues, is the smallest because of its effort to create an investable index. As Table 2 indicates, whereas Baring provides one investable index, MSCI and the IFC subdivide their emerging market indexes into "global" (that is, full) and "free" or "investable" indexes. The table shows the country coverages, by percentage weights, for all five indexes. The Baring and IFC Investable indexes are noticeably different in country coverage from the MSCI Free Index. The philosophy behind the Baring and IFC Investable indexes is to weight a market by the international investor's ability to invest in that market. The MSCI Free Index has that underlying philosophy (issues that cannot be held by foreigners are removed), but the philosophy has had a smaller impact on the characteristics of that index than on the IFC and Baring investable indexes. The different levels of investability create significant differences between some countries' weightings in the IFC Global Index, which uses capitalization weighting and includes issues that are not available to foreign investors, and their corresponding weightings in the IFC Investable Index. For example, Korea goes down from about 12 percent of the IFC Global to 2.4 percent of the IFC Investable because a foreign investor in Korean stocks can hold only 20 percent of the capitalization of any security, so Korea is included at 20 percent of its market capitalization. Taiwan is a large market in the global index, about 16 percent, but drops to 2.9 percent in the investable. In contrast, Malaysia, Mexico, and Brazil receive high weights in the Baring (investable) Index and higher weights in the MSCI and IFC investable indexes than in the corresponding global indexes. 13

Index Sub- and Supersets The broad categories of developed and emerging market indexes are augmented by many index subsets and supersets. In addition to the investable subsets for the emerging markets, MSCI has investable (free) indexes for the developed markets. Moreover, any of the providers will calculate indexes for a specific country or region, so if a portfolio manager wants the Pacific Basin without Japan, for example, that index is obtainable. Customized weighting schemes, such as the GDP weighting that has become popular, are also available, and recently, currencyhedged indexes have become available. Until recently, the international index providers did not create indexes differentiated by capitalization coverage. FT, however, has started to split its index into a large-cap subindex, which is the top 75 percent of capitalization by country, and a medium/ small-cap subindex, which is the bottom 25 percent of capitalization by country. The Salomon Index has always comprised two subindexes based on issuer size-similar to the way in which the Russell 3000 Index comprises the 2000 and 1000 subindexes. The Salomon EPAC Primary Market Index is the top 80 percent of capitalization and covers 1,684 issues; it has about the same number of issues as the MSCI World Index. When a Salomon Brothers non-U.s. index is being compared with other indexes, what has usually been compared is the PMI. The Salomon EPAC Extended Market Index, the bottom 20 percent of capitalization, is a particularly interesting index because it is the only international small-cap index available. The latest creations are combinations of indexes, or supersets. For example, the Goldman Sachs Extended Global Market Index is the FT World Index plus the IFC Investable Index. Some emerging markets are already in the FT World (Mexico, Brazil, Thailand, and Malaysia) but the addition of the IFC Investable includes more emerging market countries and provides a useful, broad international benchmark. Because managers of all kinds of international portfolios, not solely emerging market portfolios, are investing sizable portions of assets in emerging markets, people want a benchmark that has at least some emerging markets in it. MSCI is also making available a combination of its emerging and developed market indexes.

Historical Risk and Return Some marked differences show up in the various indexes' reported returns and risks for similar regions. As the top part of Table 3 reports, from mid1989 to mid-1994, the MSCI EAFE Index reported almost twice the returns of the FT EurPac Index, with 14

Table 3. Historical Risk and Return, Mid-1989to

Mid-1994

Index MSCIEAFE MSCI Europe MSCI Pacific MSCIWorld FT EurPac Salomon EPAC PMI Salomon EPAC EMI Emerging markets MSCIGlobal IFC Global IFC Investable Baring GS Extended ex U.s. S&P 500

Cumulative Return Annualized 5.01'/'0 9.82 2.05 6.44 2.94 1.81 3.02 7.88 7.28 23.67 18.08 3.03 10.33

Total Risk Annualized 20.76'1Il

-0.25 12-Month Moving Average -0.5

0

-0.75 3/86

3/89

3/92

3/86

3/95

3/89

3/92

3/95

Page's Procedure: Information Ratio

CUSUM Plot: Information Ratio a -1.5 -1.0 o

'.0

02

-0.5

g 36/22/15

0

~

24/16/11

:-5

0

]

::i 48/27/18

-0.5

60/32/21

x 9/93

72/37/23 84/41/25 f - - - - - - - - - - - - - - - I J - - -

1.0

x

3/93

1.5 3/86 "Good = 0.5; bad

3/89

3/92

3/95

3/86

3/89

3/92

3/95

= 0; very bad = 0.5.

Source: RogersCasey, based on data from J.P. Morgan and Salomon Brothers.

is the most liquid in the world, one would expect the Performance Comparison of Three Indexes differences between the two indexes to be minimal. Figure 5 demonstrates, however, that differences beA comparison of risk-return profiles shows that diftween the two indexes exist even in a such a liquid ferences in the indexes can have substantial impacts market. on risk and return. Although the scale is a bit deceivA ratio of the durations of the two U.S. bond ing because it magnifies the difference, Figure 7 indexes, shown in Figure 6, explains some of the shows that the Salomon WGBI did relatively better divergence in performance between the two. The J.P. than the J.P. Morgan GBI and Lehman Global Bond Morgan U.s. bond index has only about 80 percent Index (GBI) in the 1987-94 period. The Salomon inof the duration of the Salomon U.S. bond index. In a dex has also had higher volatility than the other two bull market, therefore, the Salomon index is likely to for the same time period. These results are highly outperform; in a bear market, the Morgan index is period dependent, however; in other periods, the likely to outperform. relative return and risk positions of these indexes have been different. A comparative performance report for the Salo38

Figure 6. Ratio of Bond Index Durations: J.P. Morgan U.S. versus Salomon U.S. 1.5

Figure 7. Risk-Retum Profiles of Salomon WGBI, J.P. Morgan GBI, and Lehman GBI, 1987 through September 30, 1994 10.0 r - - - - - - - - - - - - - - - - - ,

1.25 o

E 1.0 ......

Salomon r......\~~,,_:::::-': .~

300

"3

8;:l

U

200 100

a -100 12/79 12/80 12/81 12/82 12/83 12/84

- - Large/Value Large/Growth

12/85

12/86 12/87

12/88

------- Mid/Value - - - Mid/Growth

12/89

12/90

12/91

12/92 12/93 12/94

Small/Value Small/Growth

Note: Data as of December each year. Source: BARRA.

styles that will perform the best in the coming year. Table 1 reveals what the sponsors should have been hiring by imposing perfect foresight on the U.s. style allocation decision. The sponsor has six choicescombinations of value and growth and size-and Table 1 indicates the optimal style choice, based on annual returns, that could have been made each year from 1980 through 1993. Correctly anticipating the style with the highest performance each year would have earned the sponsor an average annual return of nearly 29 percent. Compared with holding each of the six style indexes or the S&P 500 for the entire period, style allocation would have added 10-12 percent in average annual return. Of course, few sponsors could have implemented the style strategy consistently. In addition, the frequent reallocations between value and growth and between small and large would have entailed high, and costly, turnover rates among managers. Nonetheless, Table 1 indicates the opportunity that apparently lies in understanding the performance of style subsegments.

Benchmark Characteristics The goal of benchmark specification is to replicate a

manager's investment style without impinging on the manager's potential to add value. A benchmark is usually a commercially available index, but what the managers are expected to deliver and the complexity of the pension fund may dictate a combination of indexes or a customized benchmark. No matter which of these forms is used, a cardinal rule for benchmarks is that they be specified ex ante. All of the standard indexes are specified ex ante. The practice of using the median manager as part of a benchmark violates this rule and always raises questions of fairness because the median manager is known only ex post. Ex ante specification deflects criticisms because the benchmark's performance is not known prior to its selection or construction. A second desirable benchmark characteristic is understandable construction. A standard index consists of published data, and its construction criteria are published. Customized benchmarks should be handled similarly; their construction should be simple, clear, and open. For purposes of ex post monitoring, a benchmark should be investable, and its stability should match the expected strategy of the manager. A benchmark that turns over 100 percent every quarter is useless, but if a manager has 50 percent turnover every quar-

45

Table 1. Perfect Foresight Test, 1980-93 A. Returns to perfect style allocation

Year

Style Allocation

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Small/growth Small/value Small/value Small/value Mid/value Large/growth Large/value Large/growth Small/value Large/growth Large / growth Small/growth Small/value Small/value

Annual Return 57.92% 15.03 36.52 44.62 11.59 33.30 21.68 6.50 25.15 36.38 0.18 55.94 32.32 23.37

B. Average annualized returns S&P 500 Large/value Large / growth Mid/value Mid/growth Small/value Small/growth

16.21% 16.56 15.58 17.18 15.17 17.95 12.97

Source: BARRA.

ter, a benchmark with a commensurate turnover rate may be required.

Customizing Benchmarks

broken down by value-growth splits. These specialized commercial indexes go a long way toward addressing the need for indexes that reflect desired style biases. As the standard indexes have become more specialized, an approach that has become popular is to combine standard indexes into a specialized benchmark. For example, a combination index might be value oriented but with bits chosen from largecap/value, mid-cap/value, and small-cap/value indexes. The ultimate extension would be to recognize even further refinements of style in devising a manager's benchmark. For example, a manager might be a large-cap/value manager but one who concentrates on P /E rather than price to book or has a different weighting technique than most large-cap managers. With all these possibilities available, a key question in customizing benchmarks becomes: How much detail is required? Managers will argue that each manager is sufficiently different from everybody else to warrant a very detailed approach. Sponsors in the United States, who are looking at 17,000 registered investment advisors, will argue that not everyone is different from everyone else, but they will recognize that managers can be grouped by style in some meaningful fashion. The answer to the question is that the complexity of the fund largely determines the detail of the benchmark. For example, a simple pension fund with three or four managers needs benchmarks of relatively limited complexity. A fund with 30-50 managers needs a much higher level of detail in its benchmarks and could probably justify a customized-benchmark approach. The construction of customized benchmarks can be complicated by differences in attitude between sponsors and managers. Sponsors are often much more motivated than their managers to generate constructed benchmarks. Managers often cooperate only because the sponsor has (even if a third-party vendor is constructing the benchmark) the ultimate control. The best customized benchmarks, however, reflect the willing and cooperative input of both sponsors and managers, and both parties have incentives to generate and use the best benchmarks available.

Constructing customized benchmarks is in many respects an art rather than a science. The science exists in the form of the systems, the technology, and the quantitative skill brought to bear on the construction process. Art enters the process because, in real life, the markets are messy. Systematic models impose some order on that messiness, but disorganization is inherent. The aim of the construction process is typically to generate a product that will differentiate between the returns attributable to a style and the returns that reflect value added by a manager. The standard indexes cannot capture that distinction perfectly (because they are, by definition, standard), but customizing can be expensive. So, sponsors face a trade-off. Some sponsors will decide that a custom_ ized benchmark will capture enough of the sources of performance that the costs of construction are Conclusion worthwhile; other sponsors will decide that customBenchmarks are important to sponsors and managized construction is too complicated or labor inteners for a number of reasons, and good benchmarks sive or costly. In addition, sponsors may be able to are characterized by several common characteristics. find what they need from the providers of the standFor example, the existence of market subsegments ard benchmarks, which are also providing increasdefined by such characteristics as value versus ingly complex and sophisticated subindexes. growth and size suggests that investment styles Sponsors can now buy a large-cap, or a mid-cap, or should be an important consideration in both standa small-cap index; they can buy a standard index 46

ard and customized benchmarks. Construction of customized benchmarks presents its own set of chal-

lenges, and the best such products reflect the joint efforts of sponsors and managers.

47

Question and Answer Session Christopher G. Luck Question: How acceptable to plan sponsors are normal portfolios as benchmarks? Luck: Some insist on normal portfolios; some hate them. The trend in the last six years has been for sponsors to push the idea of normal portfolios because they are the ones imposing discipline on the managers. Recently, managers have begun coming to consulting firms to have customized benchmarks built for their processes. So, a little shift has occurred in who is driving the process. Still, a relatively small group of investment professionals is keen on normal portfoliosmainly, the large pension fund sponsors, who have very complex pension fund structures. Question: Does anyone provide indexes split along lines other than growth and value? Luck: Growth versus value is not the only way of looking at the world; this split has meaning because empirical studies appear to show that it drives differential

48

performance. BARRA has looked at other factors as potential drivers. For example, instead of looking at growth and value based on price to book or PIE, we decided to examine the different results from strategies based on price momentum-that is, buying highmomentum and low-momentum companies. This particular split did not result in as large a differential performance as the valuegrowth split did. Another way to approach differences would be in terms of growth, core, and value. The core segment might be arbitrarily defined as no growth and no value. This core segment would be the stocks that have growth and value characteristics that are very similar to the overall market, which implies that growth and value stocks are only those with more extreme characteristics. Question: Do you use the same formula for defining growth and value stocks in the United States and in Canada? Luck:

No. In the United States,

BARRA uses a book-to-price screen to define the split between value and growth. In Canada, the straight book-to-price screen is quite sector dependent and seems to exclude too many high-yielding companies from the value category. So, in Canada, we use a formula of two-thirds book to price and one-third dividend yield. We use the formula to rank all stocks; then the stocks in the top half of the ranking are classed as value and stocks in the bottom half as growth. The classification is rebalanced twice a year. Question: Which indexes do the best job of style segmentation and why? Luck: Size and value versus growth are the two most important variables separating style in the market. Hence, indexes that capture that segmentation are important. Managers' strategies tend to be far more complex than simply concentrating on these two variables, however, so the question is often one of the level of complexity the sponsor desires.

International Equity Benchmarks and Manager Choice Philip Halpern Chief Investment Officer The Washington State Investment Board

Current standard benchmarks are weak proxies for the rapidly changing and expanding global investment world. Assigning a benchmark (and performing attribution analysis) that does not reflect a manager's global investment strategy, that ignores global market inefficiencies, and that trivializes high global trading costs is irrelevant and misleading.

Pension funds and other sponsors are investing heavily in international equities, but they often have difficulty identifying and analyzing international investment managers' styles. This difficulty, in turn, can lead to problems in selecting appropriate benchmarks, to the misleading conclusion that more managers are better than few, and to paying unnecessary management fees. This presentation discusses issues that are important in structuring an international portfolio as they affect choosing or developing benchmarks. It introduces research findings from several years ago on exploitable inefficiencies in world equity markets during a time of crisis. Finally, the discussion presents preliminary research findings on the excess costs resulting from hiring multiple managers.

The International Equity Portfolio Like most institutional investors, the Washington State Investment Board structures its $26 billion portfolio within the major asset classes along the lines of specific benchmarks, including some international benchmarks. The use of benchmarks for the overseas markets is still in its infancy. The construction of international benchmarks is messier and more contentious than it is in the United States or Canada. The issues of multiple currencies, cross-holdings, availability of shares, and liquidity of markets remain to be overcome, and the quality of data, although improving steadily, is still a problem. For a user, this messiness can be quite frustrating. The benchmarks used by most U.S. plan sponsors for international investing are the MSCI EAFE indexes. Several studies have presented statistically

significant evidence, however, that the EAFE indexes are not efficient, and few users seem to like them. Managers often take enormous bets away from the indexes-with decidedly mixed results. Tracking errors are almost always explained by the bet in Japan, and in nearly all cases, the manager's exposure to Japan is less than the weight of the index. One might wonder whether the accepted index truly reflects the neutral investable index as defined by the manager investing abroad. This benchmark fuzziness has obviously not discouraged international investment. Barings, which annually analyzes cross-border investments, estimates that nearly $160 billion of cross-border equity flows occurred in 1993 alone. 1 This amount equates ~o an average annual compound growth of about 37 percent during the past five years. About 44 percent of these cross-border flows emanated from the United States and Canada. The reasons for the increase in flows are well known, including the reduction in capital constraints, increase in world trade, broadening of the capital base by corporations, and trend toward securitization of assets. Despite the great amounts of investment, trading internationally still contains many problems for those used to the North American markets. These problems increase the costs of having the wrong exposure because of the expense of making a correction through trading activity. Using live data for five years, Perold and Sirri estimated the total round-trip cost of trading overseas shares to be more than 200 1 Michael J. Howell and Angela Cozzini, "Cross-Border Equity Flows: Hot or Cold?" The GT Guide to World Equity Markets 1994-1995 (Euromoney Publications, 1994):12-23.

49

basis points (bps).2 This expense is magnified as the size of a portfolio increases. For example, the Washington State Investment Board (WSIB) has $1 billion currently invested in international equities-an exposure that is targeted to increase to $3 billion over time. Because the WSIB already owns 10-12 percent, and sometimes more, of the total trading volumes of some of the issues in its active portfolios. Tripling the exposure as we move toward the $3 billion target has obvious implications. In addition, getting into and out of the small issues is not always easy. The rapid growth of capital entering the small countries has only compounded the problems by magnifying a mismatch between share supply and demand. Most overseas markets are still developing their public-market infrastructures. Even in Europe, at least until the European Union's Investment Service Directive comes into effect in 1995, most countries require local shares to be traded in the local market by locally registered exchange members. The capital requirement to become exchange members can be prohibitively high for many potential players; consequently, a few local players can dramatically affect share pricing. Many non-North American investments are in companies that have majority shareholders or majority control in which nondomestic investors cannot share. Finally, although the situation is improving, voting restrictions, limited insider-trading laws, and market manipulation outside North America continue to make governance problematic and difficult for the investor. For these reasons, sponsors must expend significant energy when developing a structure for overseas investments. The relevant benchmarks for performance measurement should logically flow from the goals of the international program. The greatest benefit of benchmarks may not lie in performance measurement, however, but in instilling a discipline that helps sponsors in their construction of international portfolios through encouraging broad exposure and reduction of the waste that results from portfolio turnover.

Efficiency in International Markets Benchmarks are meaningful only to the extent that markets are efficient; the more individual portfolio managers operate in inefficient markets, the less meaningful benchmarks become. Although the world is moving toward easy and cheap capital flows among markets, the markets will continue to be segregated to some degree for some 2 See Andre F. Perold and Erik R. Sirri, "The Cost of International Equity Trading:' Harvard Business School paper, forthcoming (Fall 1995).

50

time. Interest rate differentials-nominal and realillustrate this segregation most poignantly. For example, can anyone explain why long-term Australian bond rates are 300 bps higher than those of Germany? By most measures, inflation differences between the two countries are small. In a perfectly homogeneous world, these differences would be arbitraged away, but they are not. The world's local stock markets do not move together. Varying nonsystematic risk characteristics are undoubtedly part, but not all, of the reason. According to most attribution analyses of managers in WSIB's most recent request-for-proposal (RFP) process, 40-70 percent of return in excess of the benchmarks can be accounted for by country selection. Currency selection accounts for, on average, a quarter to a third of excess return, and stock selection the remainder. In almost all cases, stock selection versus the index is the variable with the least impact on differences in manager returns. In these RFPs, many managers exhibited negative excess returns for either currencies or stock selection but had positive returns overall because of country selection. Although no attribution technique is perfect, in almost every case with a myriad of attribution characteristics, country selection tends to dominate. The questions, then, are: Can researchers prove that a statistically significant level of managers, in aggregate, add value, and if so, when? To help answer these questions, this presentation reviews a previous study that posed the question this way: Are stock markets inefficient enough to be consistently exploitable by money managers?3 That research explored the questions in a number of ways, always focusing on country selection as the primary decision. The time period was 1988 through 1990. During the Iraqi invasion of Kuwait from the beginning of August 1990 to the end of 1990, the world capital markets were extremely volatile, so the study treated this period separately. The study applied both cross-sectional and timeseries techniques to measure managers with EAFE mandates. The study first hypothesized that active country bets away from the EAFE Index exposures might be correlated with certain total return components. MSCI's EAFE Index was assumed to approximate a true manager benchmark, although arguments against this assumption could certainly be made. Each month, managers would decide what country exposures to take; these country bets would be determined by anticipated returns of the markets in local terms, anticipated value added by specific stocks in those markets, and anticipated currency 3 Philip Halpern, "Investing Abroad: A Review of Capital Market Integration and Manager Performance:' The Journal ofPortfolio Management (Winter 1993).

movements against the U.s. dollar. in explaining preinvasion country bets in general but much less significant in explaining the direction of In the two and a half years prior to the invasion, changes in those bets. If transaction costs were the a manager's country decisions appear to have been reason managers' portfolios differed from the optifavorably affected by all three criteria at a statistically mal portfolio, one would expect directional moves significant level. During the crisis period, however, for the exposure weights to be more positively sigthe only variable that seemed to add value was the nificant than the study found. Therefore, portfolio manager's ability to realize excess return within the exposure weights that deviated from the EAFE Index local stock market. That is, a manager earned money must have been caused by some factor other than by picking stocks, not so much by country allocation trading costs and active bets. The conclusion as to or currencies. that cause is that EAFE was not the managers' norNext, the study hypothesized that these decimal portfolio. Thus, mandating an EAFE benchmark sions were biased by managers managing against a does not seem to matter if the intention is risk control benchmark that was not truly the EAFE Index. All and performance measurement. the variables were normalized against the EAFE In this connection, a third conclusion is that typiweights, but if the true benchmark portfolio was not cal attribution analysis may not be appropriate in known, the managers' decisions could be tested only measuring sources of value because managers' norby examining the directional moves of the portfolio. mal portfolios may not be the stated benchmark That is, managers would move every month into a portfolios. Directional moves may be a better way of country they believed would have excess returns, establishing the information content of a manager's and although biases might still exist, those movedecisions. ments in and out of the countries should reflect the The fourth conclusion is that bottom-up stock managers' true beliefs of what was going on in the apparently does not lead to good overall picking countries. country allocations in aggregate. The result of the The answers were somewhat different from the decision to go into countries because of identifiable first set of answers. Basically, during the preinvasion nonsystematic bets was actually perverse in many period, the local market returns across countries cases. In other words, when managers won, their were significantly positive and the other variables winning was often credited to luck. were not significant. The hypothesis that managers Finally, currency forecasts are apparently not will move into countries because they identify good embedded in buying stocks in countries. The analystocks seems not to hold, and the currency effect sis suggests that currency should be viewed sepaseems to be neutral. During the crisis period, country rately-perhaps as a separate asset class. selection was somewhat less than statistically significant, but it was high and added some value, while the remaining factors do not seem to have mattered. Multiple International Managers and Excess A subordinate part of the study was to discover Trading Costs whether managers make good decisions in terms of currencies. That is, are the currency markets efficient The WSIB is trying to decide how many managers to or do they contain exploitable inefficiencies? The hire for its international portfolio. The argument for independent variable tested was the return from hiring more than we have, with different styles, rests active currency bets-not bets embedded in stock on the benefits provided by diversification-lower selection, but actual, active decisions to hedge or not volatility, less exposure to manager business risk, to hedge. During the preinvasion period, currency and so on. But to achieve diversification through a bets definitely added value to the managers' posimultiple-manager structure will create higher tradtions, which was not the case during the volatile ing costs and management fees. For example, as the invasion period. number of managers increases, the probability that This study led to a number of conclusions. First, one is buying exactly what another one is selling the managers did add value through country deciincreases. The sponsor ends up at the same place but sions during normal times and times of crisis, which pays trading costs to get there. In the international suggests that markets are not efficient relative to one markets, where an investor may be paying 200 bps another; at least, they were not during the periods round-trip, such a situation makes even less sense tested. Second, even though all the managers said than in domestic markets. EAFE was their benchmark, it is unlikely that the Therefore, we have developed a framework for managers really used EAFE as the normal portfolio analyzing the probability and cost of managers buyduring the time of the study. The argument behind ing and selling identical stocks in a country. Figure 1 this conclusion can be summarized as follows: Local depicts the manager trades (MY) for two managers, market return comparisons were highly significant i and j, in country q. The shaded area would consti-

51

Figure 1. Excess Trading Costs with Two Managers MT(i,q)

MT(j,q)

t

Excess Trades

count value for manager n. Ignoring relative differences in price appreciation for simplicity, a manager's expected trade in any one country is assumed to be a random variable MT(n,q), which is normally distributed with E[MT(n,q)] = O. A positive variance is a purchase and negative variance is a sell. In the aggregate portfolio, sales will offset purchases so that MT(n) will equal zero for each manager. The expected monthly sales, when sales occur, can be expressed as

Source: The Washington State Investment Board.

tute excess trades from the sponsor's perspective. The framework is intended to generate a bivariate normal distribution of that excess trading, using the dollar size of the trades to differentiate the excess costs incurred when one manager is buying and another manager is selling the same asset. Assume an investor hires N managers to construct a portfolio around a benchmark that includes Q countries. In the long run, the amount of monthly trades executed by the managers reflects two characteristics: the sale and purchase opportunity set for each country in the portfolio and the individual managers' portfolio turnover philosophies. For simplicity, the model also assumes the probability of trading to be equal for each country within individual manager portfolios. Decisions are made monthly. Turnover percentage, TO(n), may differ among managers but is expected to be similar for each country within each manager portfolio. The term Port(n,q) represents the portfolio amount of manager n in country q; Port(n,Q) represents the total portfolio ac-

and the monthly purchases can be defined as

The model then calculates the expected excess trades between each pair of managers. Table 1 presents the results of the analysis of excess trading costs for a test case. The case involved a $360 million portfolio equally divided among managers; no appreciation or cash inflows or outflows were assumed. Each manager, whether a regional manager or EAFE manager, was assumed to invest in the same country against similar benchmarks. (As argued earlier, different normal portfolios would result in different country exposures and trading patterns. For simplicity, this test assumed similar normal portfolios across managers. Unless normal portfolios are extremely different, the impact on results would be minimal.) Portfolio decisions were assumed to be made monthly. Beginning manager 4

Details of the model are available from the author.

Table 1. Effect of Number of Managers in a Portfolio on Trading Costs: Test Case Assumptions: Total trades Total trading cost Trading cost (country allocation)a

$259 million $5,184 thousand, or 144 bps $2,592 thousand, or 72 bps Number of Managers 2

3

4

5

Expected sales/purchase in each country for each manager (thousands)

$1,350

$900

$675

$540

Standard deviation of sales/purchase in each country for each manager (thousands)

$2,000

$1,330

$1,000

$800

Total excess trading cost Dollars (thousands) Basis points Percent of total trades

$332 9.2 6.3%

$631 17.5 12.2%

$891 $1,188 24.7 33.0 17.1% 22.9%

aFifty percent of all trading is assumed to take place in order to make country allocations; fifty percent is assumed to take place for individual security bets.

Source: The Washington State Investment Board.

52

portfolios were equally weighted among countries, should evaluate the diversification benefit versus this waste. although this assumption is not necessary and does not affect the results dramatically. The turnover was assumed to be 72 percent a year (6 percent a month), which is on the low side of the normal range for most Conclusion active managers. Half of that turnover was related Benchmarks should help sponsors attain the ultisolely to country selection, and the rest to individual mate purpose of investing-to make money. Therestocks. The next assumption for the test case is key: fore, forcing the world into a benchmark paradigm Based on anecdotal observations, international manthat does not reflect real-world opportunities is simagers' moves in and out of the markets apparently reflect almost no correlation on a directional basis. ply silly. The investment world is dynamic; it is Therefore, a.1O correlation of manager country-allochanging and expanding, and the current standard benchmarks are weak proxies for that world. The cation trading decisions was assumed. Finally, all numbers were reported on an annual basis. greater the volatility and changes in the real world, the less meaning benchmarks have-as investment Table 1 shows the excess trading costs for two, goals or as measurement tools. three, four, and five managers. (In the model, the number of countries is irrelevant. The amount of Understanding what a portfolio manager is doing and what is the manager's normal position is trading into and out of any pair of countries is offset difficult. Performing any sort of attribution analysis, by the number of cross-trading opportunities.) As shown, total excess trading costs for two managers even with appropriate benchmarks, is tenuous, were found to be 9.2 bps. That is, a sponsor with two therefore, but assigning a benchmark that does not reflect a manager's investment strategy is irrelevant EAFE managers or two regional managers, as the two managers conducted some trades that canceled at best and misleading at worst. each other out, would be overpaying by 9 percent. If Understanding the key issues in global investthe number of managers with similar mandates is ing, potential inefficiencies in global markets, and increased to five, the excess trading costs increase to the impact of high global trading costs (particularly in connection with using multiple global managers) 33 bps. can help the sponsor stay on track in the difficult A sponsor trying to devise a structure for investtasks of assessing performance in global markets. ing the funds earmarked for international equity

53

Question and Answer Session Philip Halpern Lawrence S. Speidell, CFA Question: Could you briefly outline where the 200-bp roundtrip trading cost comes from for international securities? Halpern: From Perold and Sirri. They looked at the commission, the bid-ask spread, the turnover taxes, the market impact, and the implementation shortfall, which is their concept of the costs of not being able to trade when somebody wants to trade. Question: Please explain your comment that performance benchmarks become less relevant through time if the markets are inefficient. Halpern: If the client cannot define the universe by which the manager is investing, then to try to characterize that universe via a published benchmark or a normal benchmark, which is then misspecified, will not tell you what is really going on in terms of the opportunities.

The volatility of return that the manager will realize will be much greater than the benchmark, and the information content will be much less. Question: Are international small stocks primarily a local, retail investor market? Speidel!: The international markets are no different from the US. market in that regard. Certainly, those who are brave enough to move away from the large, comfortable stocks and pioneer in the small-cap stocks, where the opportunities may be greater, have to deal with liquidity problems and information problems. I think the reward is worth the risk, but the problems do exist. Question: Are institutional investors entering the international small-cap market? Speidel!: I do not have much company right now, but I think

the trend is in that direction. Question: How do you identify small-cap international managers? Speidel!: Finding good international managers is difficult. I would start with where the sponsor wants to be in terms of the world and try to find managers whose exposures closely mirror the sponsor's objective. The manager's experience in those areas is important because the international markets are both riskier and more complex than the domestic market. The manager's investment results are important, but results can be indicative of only one or two individual bets. More important than basing a decision on historical performance is determining that a manager has the infrastructure, experience, and skill to manage in the global markets and to sustain good returns.

67

Market Homogenization and Diversification Benefits Lawrence S. Speidell, CFA Director, Systematic and Global Management and Research Nicholas-Applegate

The diversification benefits long associated with small-capitalization and global investing appear to be intact. Correlations between small- and large-cap stocks and between U.s. markets and developed and developing markets indicate that markets are not becoming more homogenous.

Conventional wisdom holds that equity markets, in becoming more globalized, are also becoming more alike, with fewer barriers and inefficiencies. If this is truly the case, investors must rethink the diversification potential of global investing activities. This presentation discusses two questions related to this issue, one explicit and one implicit. The explicit question to be explored is: Are the markets around the world becoming more alike, more homogeneous, than in the past? The implicit question that follows from the first is: If so, what are the implications for investors in their search for real diversification? The presentation addresses these issues on two levels-first, whether markets are homogeneous within themselves, and second, whether markets around the world are drawing closer together. Are global markets becoming one basket; is trading 24 hours around the clock causing all markets to act the same way?

Internal Homogeneity The first issue for the global investor is whether the non-U.s. equity markets are homogeneous within themselves. This issue has been studied previously, with the conclusion that an investor needs fewer stocks in non-U.s. markets than in the u.s. market in order to achieve a portfolio that tracks the local market. In other words, non-U.s. stocks have a higher correlation with their local markets than do U.S. stocks with theirs. This answer needs to be amended, however, with respect to stock size. Small stocks move independently in most markets. Figure 1 is a comparison of the MSCI EAFE Index and the Salomon Brothers 54

EurPac Extended Markets Index (EMI) for small stocks for the period of June 1989 through September 1994. (All calculations in the figures are in U.S. dollars.) Salomon Brothers uses an 80 percent/20 percent rule to define large and small capitalization; thus, the bottom 20 percent of stocks in market capitalization are categorized as small cap in each market. Salomon also mandates that in order to move to large-cap status, a small-cap stock must move at least 5 percent (top 75 percent cap) into the large-cap region. Figure 1 shows that, globally, the small stocks do behave differently from the large stocks. Figure 2 supports a similar conclusion with data for four of the non-U.S. developed markets; in the international arena, large cap is distinct from small cap just as in the U.s. market. Figure 2 also reveals similarities and differences in stocks' relative performance among national markets. In the United Kingdom, the relative performance graph shows that small stocks relative to large stocks bottomed in about the second half of 1992; this development was followed by strong improvement for the small-cap stocks. In Germany, however, relative small-stock performance was weak from 1989 to 1992 and has been flat since then. In France, small stocks were weak through the end of 1992 and have been strong since then. Figure 3 suggests some coincidence of the economic cycles in these markets, as defined by industrial production, with the capitalization performance cycles. For example, the u.K. market bottomed in terms of industrial production at about the same time small stocks picked up. In the U.s. market, small stocks have performed better since industrial pro-

Figure 1. Performance Comparison of the MSCI EAFE Index and EurPac EMllndex 6/89=100 200

180

160 -

140

.

.'

120

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Mexico Thailand

0 3

4 7 6 5 Capitalization Deciles (small to large)

8

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Source: Nicholas-Applegate.

Figure 8. PJBV versus Market Capitalization for Peru, November 1994 10 , - - - - - - - - - - - - - : - - - - - - - - ,

9 8 -

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Note: Log return. Source: Nicholas-Applegate.

61

Figure 9. Five Years of Quarterly Returns: Germany versus the United States, Third Quarter 1986-First Quarter 1991 0.3

0.2

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u.s. Returns (%) Note: Rolling five-year correlations. Source: Speidell and Sappenfield, "Global Diversification in a Shrinking World," p. 61.

62

0.1

0.2

Figure 10. Rolling Fiv~Year Correlations of Developed Country Markets with the United States Canada

France

1.0 , . . - - - - - - - - - - - - - - - - - - - ,

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Peers

Manager

b.

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Source: Richards & Tierney.

of the organizations that the manager considered to be its peers lie, in fact, quite far from the style space in which the manager's portfolio lies. In short, the peer group that our client manager wished to be compared with was quite different from the client; most of the individual peer managers-and the average peer manager-would be characterized as small-cap / growth rather than large-cap / growth. Such distances can represent significant performance differences over time. This evidence is anecdotal, but it illustrates poor specification of peer groups and the potential presence of style misspecification. International manager universes are probably worse than domestic ones. The diversity of manager mandates in the international area is wide and hinders the creation of peer groups based on similar style. The usual alternative is to compare an equity manager with the MSCI EAFE Index or another international market index. The EAFE Index is largely irrelevant as a benchmark for many international managers, however, because it inadequately represents their investment tendencies. For example, most international managers maintain a permanent underweight in Japan by using the EAFE Index as a benchmark. Clients, consultants, and managers should devote their energies to constructing better, customized international benchmarks rather than promoting the flawed techniques of universe or EAFE Index comparisons. The conceptual weaknesses associated with manager universes and the presence of survivorship bias and style misspecifications in manager universes suggest that manager universes may not accomplish their intended purposes.

Quality Tests Given the problems associated with using manager universes, a set of criteria is needed that can measure the quality of a benchmark in an objective way-a set of objective measurements that would indicate whether a benchmark is successful. The first five criteria suggested here relate to the composition of the benchmark portfolio itself, and the others relate to the benchmark composition relative to the actual portfolio under review. Coverage. An analysis of benchmark coverage would involve simply discovering whether the stocks in the actual portfolio or the managed portfolio are also contained in the benchmark. Turnover. Benchmark turnover refers to the percentage rate of change in the composition of the benchmark. It relates to investability: Is the turnover rate reasonable in light of trading realities? Positive active positions. This criterion calls for considering whether the manager that is to be compared with the benchmark holds favored stocks in disproportionately higher weights than those same stocks are held in the benchmark. If the manager likes a stock, the manager will typically be weighting it more heavily than does the benchmark. Investable position sizes. This criterion relates to evaluating whether the benchmark weights can be duplicated by a particular manager. If a certain stock makes up 3 percent of the benchmark, can this manager under review actually hold 3 percent of that stock in its portfolio? This criterion is particularly relevant to multibillion dollar managers. Similarity of portfolio characteristics. Do the portfolio and benchmark share similar characteristics, particularly with respect to style? Figure 1 illustrated one way of, and the importance of, analyzing the similarity in composition of a benchmark and a specific portfolio. The next three criteria are more complex than the first five in that they relate to comparing the returns of a managed portfolio with a benchmark's returns. Observed active risk. Analyzing this criterion involves examining the amount of variability of portfolio returns relative to the benchmark. Examination of the median manager benchmark should show whether it was successful in reducing the amount of active risk in the past compared with an alternative such as the S&P 500. For example, if a largecap / growth universe explains a manager's performance well, the manager's past performance should reflect less active risk relative to that benchmark than to the S&P 500.

Correlation of managed portfolio returns versus the market with benchmark style returns versus the market. If the benchmark is appropriate, the returns of the benchmark in excess of market returns should be 111

highly positively correlated with excess portfolio returns. In other words, if a benchmark is a good reflection of a manager's investment style, the manager's portfolio should perform well at the same time the benchmark performs well relative to the market.

Correlation of benchmark style returns versus the market with the managed portfolio returns versus the market. This correlation should be low. How success-

relatively unrelated to the returns of the manager under review. This experiment involves only one manager for one time period, of course, and the results may not be true in every period. The point is that those who provide manager universes should publish information that supports the validity of the median manager as a benchmark for evaluating performance- that is, demonstrates an acceptable correlation between the returns of median managers and those of individual managers.

ful the manager's style is in a particular market should have no bearing on how the manager adds value to the benchmark. That is, whether the market is good or bad for, say, large-cap/growth stocks should not affect a manager's performance versus the large-cap / growth benchmark. Conclusion Now, consider applying these objective tests to the median manager of a manager universe, perhaps Although manager universes may be convenient and the most widely used manager performance benchappealing, comparing performance with manager mark. The first five benchmark quality criteria canuniverses does not make sense. Manager universes not be applied to a median-manager benchmark are hopelessly inadequate tools for conducting perbecause analysts never observe the composition of a formance evaluation or manager risk control. median manager's portfolio. This problem gets to the Managers and plan sponsors argue for the use of heart of the inadequacy of manager universes: They manager universes for comparisons because the are ambiguous and uninvestable benchmarks that available asset-list benchmarks are so poor. This reare specified after the evaluation period. sponse is wrong. Instead, managers and their conThe three remaining benchmark quality tests sultants should focus their energies and efforts on deal only with returns, and therefore, they can be constructing improved customized benchmarks. applied to, for example, the median manager from a With today's technology, constructing custom manager universe. Table 2 uses the quarterly perbenchmarks for individual managers makes more formance of a managed large-cap / growth portfolio, sense than accepting general manager universes. Inof the median manager from a large-cap / growth deed, custom benchmarks are increasingly in use. universe, and of the S&P 500 to apply the three tests. Even on the international level, where custom benchThe time period was from the first quarter of 1985 marks have not yet been widely applied, benchmarkthrough the second quarter of 1990. The test of obbuilding technology is becoming available. served active risk appears in the column for annual What characteristics, then, would the ideal peer standard deviation. The managed portfolio's pergroup in a custom benchmark possess relative to a formance relative to the S&P 500 had an annual manager's portfolio? The ideal peer group, in comstandard deviation (observed active risk) of roughly parison with the manager under review, would 5.7 percent. The manager's performance relative to • be selected from the same sectors and industhat of the median manager from the largetries (and only those sectors and industries); cap / growth universe had an annual standard devia• be selected from (and only from) the same tion of almost 8.1 percent. In other words, noise is market-capitalization groups; introduced in the process simply by using this me• be selected from (and only from) stocks with dian manager's performance as the benchmark. This similar common factor exposures; scenario is not reassuring in terms of the quality of • incorporate the same legal or policy restricthe benchmark. tions on security holdings; The desired large correlation between perform• apply similar weightings to portfolio securiance of the large-cap / growth median manager verand ties; sus the market performance and performance of the specific portfolio manager versus the market per• exhibit similar total portfolio characteristics. These characteristics are grounded in the same formance is not present; the actual correlation is only 0.26. On the other hand, the correlation between the approach as would apply to constructing a customized asset-list benchmark. The implication is that manager's performance versus the large-cap / growth median manager and the median manager versus the manager universes are poor substitutes for carefully market should be near zero but, at -0.45, is not only designed benchmarks that are created specifically for the unique investment process of individual managnegative but fairly high. The indication is that the returns of the median manager in the universe are ers.

112

VJ

,...,...

1.00 0.26 0.72

Note: The market is the S&P 500. Source: Richards & Tierney.

aRate of return divided by standard deviation.

Managed versus market Benchmark versus market Managed versus benchmark

Managed versus Market

1.00 -0.45

1.00

1.10

2.87% 1.76

8.09

5.67% 5.89

Annual Standard Deviation Annual Rate of Return

Performance Statistics

Benchmark versus Market

Managed versus Benchmark

Correlations of Excess Returns

0.14

0.51 0.30

Informati Ratioa

Table 2. Benchmark Quality Results: Managed Portfolio, Median Manager, and Market, First Quarter 1985 through Second Quarter

Question and Answer Session JefferyV. Bailey, CFA Michael J. Flynn Question: What is the appropriate time frame to rebalance a manager's custom benchmark? Bailey: A custom benchmark for an equity manager should be rebalanced quarterly or semiannually. The characteristics of stocks can change over time. For an extreme example, IBM used to be a growth stock, but it certainly is not today. If you do not rebalance frequently, the characteristics of the benchmark will change from what you were trying to capture initially. Question: Who pays for custom benchmark work, and how do the costs compare with those of manager universes? Bailey: Manager universes are somewhat like derivatives: They are by-products of systems that are primarily designed to generate other products. For instance, bank trust departments collect a great deal of data, from which investment manager universes can be constructed; so, a universe built on that data base is essentially free. This kind of benchmark becomes something of a loss leader for the provider. At Richards & Tierney, we believe managers should produce and pay for their own custom benchmarks. This system puts the responsibility and accountability for quality benchmarks where they belong-in the hands of managers. Custom benchmarks are expensive to produce because they take time and thought, but the issue is whether you get what you pay for. Most people pay nothing for manager universes, and I suspect they get results in accordance. 114

Flynn: Custom benchmark work is expensive and time consuming, which helps explain why universes and peer groups are the more widely used approaches. Whether the benefits are worth the cost and effort comes down to whether an appropriate universe or peer group is available and whether you are willing to go the extra mile to use custom benchmarks. The use of custom benchmarks generally requires hiring an investment consultant and paying significant fees to develop and regularly adjust the benchmarks. All of the fees being paid ultimately affect the investment performance (the bottom line) of the fund being evaluated. So, the question is whether any incremental value that is added is worth the expense. Question: Are consultants relying on universes to assess performance because using universes is easy? Flynn: The consulting process involves determining clients' needs and applying what is most appropriate for them. Using universes or peer groups is not necessarily the easiest approach, nor does it involve less work than some other approaches, but it is easily understood by clients. A consultant using a universe/peer group must first spend a lot of time ensuring that the universe/peer group applies appropriately to the fund being measured. In some cases, client portfolios do not compare directly with available peer groups or universes, and the consultant and client must consider whether to devise custom universes, peer

groups, or benchmarks. Again, an expense is associated with such customization, and given alternative performance measurement tools and a client's objectives, the expense may not be cost-effective. Question: Because most manager searches start with a requirement that managers be in the top quartile of performance to be considered, what responsibility do consultants have to understand the problems in using manager universes and to consider such issues as survivorship bias before eliminating managers from further consideration? Bailey: The basic issue is that manager universes do not provide a valid comparison tool in the first place. Manager universes are completely invalid. For a manager organization to say it is in the "top quartile" means nothing to me. Consultants and fund managers should not be doing something with nothing. Question: Are the Morningstar reports meaningful in evaluating fund managers? Bailey: Some of the research Morningstar does is wonderfulfor example, some sophisticated risk analysis. Morningstar's comparisons among peer groups, however-reports on how a fund did last quarter or last year versus its so-called competitors-are not meaningful. Morningstar has the data and is capable of combining various style portfolios to produce a custom benchmark, which would be useful, but this work has a long way to go. Flynn:

If you want a quick re-

view of a mutual fund's performance versus that of its peer group, Morningstar is useful. We break out Morningstar's return data to create some custom benchmarks and peer groups, which we apply and use. So, Morningstar is a good start. I agree, however, that it needs to go much farther. If you are simply applying Morningstar information as it is presented, without refinement or extension, you are going to get in trouble. Question: Do universes in which the vendor does its own analysis of managers' styles vary significantly in quality or veracity from those in which the managers designate their own styles via a surveyor other techniques? Bailey: Good research on the quality of these universes is lacking. The organizations that have the data do not publish anything. Flynn: Although you need to understand what makes up the peer groups and universes, the organizations that create universes generally do not provide this information. If you are trying to compare apples with apples and you have no idea whether you have apples in both sets, you cannot make a valid comparison. Question: Mr. Flynn, do you agree with the claim that survivorship bias pushes median returns significantly upward and that this problem significantly compromises the integrity of a universe as a performance measurement tool? Flynn: Several types of survivorship bias exist that can compromise the integrity of performance universes. I believe the type of bias you are referring to is the inability of performance universes (because of the calculation methodology) to capture the per-

formance of managers that underperform and eventually go out of business. This type of bias does exist and it can upwardly skew returns. The frequency at which it occurs is low, however, and the impact it has on the overall universe is small. The bias is not significant enough to invalidate the use of universes. Question: Mr. Bailey, other than superiority in market timing and transaction costs, what information can be gained by constructing a peer group or benchmark that nearly mirrors a managed portfolio? Bailey: The goal of benchmark building is not to mirror a manager's portfolio. Rather, the goal is to create an investable portfolio that mirrors a manager's investment style. The distinction may seem subtle, but it is crucial. A manager adds value by selecting the best-performing stocks and avoiding the worst-performing stocks from his or her benchmark. Question: Which is the more appropriate benchmark for a manager: a universe of separate accounts or a composite? Flynn: The type of universe that is most appropriate depends on the type of portfolio you are trying to evaluate. To make the best comparison, the universe's objectives, restrictions, structure, and so forth, should be similar to the portfolio you are measuring. If I were attempting to measure the performance of a separate account, I would prefer to use a universe created from separate accounts. The opposite would be true if I were measuring the performance of a composite fund return. Question: For mutual funds, would a direct comparison with a

benchmark be more appropriate to evaluate performance than using a comparison of a given fund's returns with the universe of mutual fund returns? Bailey: I believe so. In an investment performance context, mutual funds are no different from other investment managers. They display certain investment styles, and their results can typically be best evaluated by comparison with custom benchmarks. Flynn: In an ideal world, I would prefer to use both a benchmark and a peer group. For a mutual fund, I would prefer to use a peer group of other comparably managed mutual funds. A peer group would provide an actively managed comparison that could be tailored to the management style of the fund you are evaluating. A disadvantage would be the amount of time and effort needed to develop the peer group and the possibility of survivorship bias. Custom benchmarks can also be tailored to match the fund's investment style. Custom benchmarks are even more time consuming and costly to develop, however, than peer groups. For the purpose of evaluating the results of a single mutual fund, the costs might be prohibitive. Question: Why do almost all managers show a universe comparison in their marketing materials if it is of no benefit to facilitate manager-elient dialogue? Bailey: Convenience, availability, and naive appeal are at the heart of the popularity manager universes are enjoying. Plan sponsors and managers should be more aggressive in pointing out the flaws of peer comparisons and the advantages of custom benchmarks. 115

Flynn: I do not agree with the statement that performance universes do not facilitate managerclient dialogue. As far as the use of universes versus passive benchmark (standard indexes) by investment managers in marketing presentations is concerned, managers will always attempt to "put their best foot forward" by comparing themselves with whichever (reasonable) benchmark or universe makes them look best. Sometimes, a manager may look best when compared with a passive index, and sometimes, with an active universe. Managers may find custom benchmarks difficult to use in marketing. Explaining a custom benchmark to prospective clients in a marketing presentation is difficult and often beyond the scope of the presentation. In addition, prospective clients are normally attempting to compare prospective managers, which is not facilitated by custom benchmarks designed to evaluate specific investment managers. Question: The median for individual manager returns compounded over a period of several years is significantly different from the median taken one year at a time, and few managers consistently beat the index over time. Is the use of median managers fair? Flynn: The compounding of median manager returns over several periods is not the correct methodology for calculating universes' distributions over long periods. This process will upwardly bias returns. The more correct

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method is to use the median manager return over the full time period. Linked median returns that are different from median returns calculated over the same period do not necessarily indicate that universes have significant survivorship bias. Rather, most of the variation can be explained by the effect of compounding returns and the volatility of the median manager returns relative to the performance of the entire universe. Question: What analytical tools do consultants use to analyze a manager's style? Flynn: Investment consultants use a number of quantitative and qualitative techniques to evaluate the style of an investment manager. Perhaps the most popular quantitative method in use today is a "style analyzer"-a form of constrained multiple regression in which manager returns are regressed against several different style indexes. The results of the regression indicate the level to which a manager's investment performance is attributable to each of the indexes. Although quantitative techniques are helpful, Stratford Advisory Group emphasizes qualitative techniques that place more weight on meeting with investment managers, understanding their investment processes, and evaluating the holdings in their portfolios than on quantitative tools. Ours is the more costly and time-consuming approach, but we think it significantly enhances our ability to as-

sess a manager's investment style accurately. Question: The AIMR Performance Presentation Standards state that you cannot take a manager's returns out of your composites if, for example, that portfolio manager is fired for poor performance. Why isn't the same idea applied to peer groups and universes to eliminate survivorship bias? Bailey: That sort of analysis would be interesting, but it would entail more effort than the universe providers would be willing to undertake. Flynn: To include managers who no longer report performance data would be impossible because universes are built on performance data from the most recent reporting period-generally the most recent calendar quarter. If a manager is no longer in business or no longer providing performance figures, the manager cannot be included in the universe. Question: Why is survivorship bias a problem if the purpose of performance reviews is to find superior performance? Bailey: Because survivorship bias distorts one's definition of "superior." The limited evidence indicates that, over time, survivorship bias can shift the "median" return more than one quartile from what it would be in a universe that is not subject to survivorship bias.

AIMR Performance Presentation Standards: An Update Michael S. Caccese Senior Vice President, General Counsel, and Secretary AIMR J. Paul Dokas, CFA Director, Trust Investment Management Bell Atlantic Edward P. Rennie, CFA \!'ice President Pacific Investment Management Company

Development of the AIMR Performance Presentation Standards has matured to the point of global recognition and acceptance of the standards. Controversy still surrounds several aspects of the standards, however, and initiatives are underway to address unresolved issues. Practitioners report that the standards have enhanced and improved the investment industry. Compliance with the standards does not detract from a company's operation in any way.

AIMR became involved in developing and setting industry standards for performance reporting because potential investment manager clients needed a mechanism for comparing managers' performance results. That development process has now matured to the point at which the AIMR Performance Presentation Standards (PPS) are becoming globally recognized. 1 Numerous issues remain to be addressed, however, and a variety of initiatives are underway to enhance and fine-tune the standards. This presentation first provides an overview of industry acceptance of and regulatory interest in the standards. It then addresses a number of issues that are in various stages of incorporation into the standards. These sections are followed by comments on the PPS from the plan sponsor and investment manager points of view.

Overview and Current Issues

Michael S. Caccese

serve as a foundation for a discussion of current PPS development activity. First, the standards are guiding ethical principles that are intended to achieve full disclosure and fair representation of performance presentation; they are not performance measurement standards. Even though some performance measurement requirements are included in the standards, those requirements are minimal and not unique to the PPS. Second, the standards are intended to ensure uniformity in reporting performance so that results are directly comparable among investment managers-that is, so that clients and others will be "comparing apples with apples." Third, the standards require firmwide compliance, not composite compliance. This requirement avoids the "cherry picking" of accounts and composites. Finally, AIMR intends that the standards be user friendly and user responsive; the AIMR Performance Presentation Hotline (804/980-3604 and fax 804/980-8789) are two manifestations of that intent.

A brief review of the nature of the standards will IThe standards as of 1993 are available in Performance Presentation Standards (Charlottesville, Va.: AIMR, 1993).

Industry Acceptance The standards have been accepted far beyond 117

the expectations of AIMR and its predecessor organizations, the Financial Analysts Federation and the Institute for Chartered Financial Analysts. Performance is increasingly being collected and reported in composites, and more and more firms are claiming compliance with the standards. Such firms include the Mobius Group, EFFRON, Wilshire Associates, Nelson's Publications, and the Money Market Directory. Numerous surveys measuring the acceptance of the standards have been conducted since late 1993. Greenwich Associates reports increasing familiarity among different groups with the standards: Familiarity with the standards is indicated by 61 percent of endowments, 44 percent of public funds, 36 percent of corporate funds, 85 percent of funds with more than $1 billion in assets, and 85 percent of funds with less than $100 million in assets. 2 Familiarity with the standards has increased during the past three years among these entities as a group from 28 percent to 45 percent. The Greenwich survey reports that public funds require the highest level of compliance. Three-quarters of public funds claiming familiarity with the standards require manager compliance. These statistics, which are confirmed by the Spaulding Group, show that sponsors of medium-size pools of assets are making the most demands for compliance with the standards, and despite the significant financial cost, investment management firms are imposing firm compliance with the standards. The Spaulding Group surveyed 550 managers about compliance with the standards in December 1993.3 Of the 27 percent who responded, 75 percent are in compliance and 20 percent plan to be in compliance. Of the firms in compliance, 80 percent comply to gain a marketing advantage, 61 percent comply because they are AIMR members, and 38 percent comply because of client pressure. The International Performance Forum reports that 48 out of 70 firms claim compliance with the standards. The Institute for Private Investors reports 45 out of 50 investment advisors for private investors claiming compliance. Pension plan sponsors and major fund managers are some of the main proponents of the standards. AIMR maintains a list of more than 300 fund sponsors and investment managers that endorse the standards (endorsement means that they require potential managers to present performance in compliance with the standards), including General Motors, IBM, AT&T, 2Greenwich Associates, Seismic Shift in Pension Planning (1994). 3 The Spaulding Group, Performance Measurement Survey (December 1993).

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Fidelity Research and Management Corporation, Templeton Worldwide, and J.P. Morgan & Company.

RegUlatory Interest The SEC staff is also displaying an increased interest in the standards. At a recent conference sponsored by the National Society of Compliance Professionals, the associate director of the SEC Division of Investment Management publicly stated to more than 150 compliance professionals that the SEC staff has no present intention of recommending to the commission performance presentation standards for u.S.-registered investment managers. The SEC looks to AIMR to fill this void and encourages AIMR to continue to expand its efforts to address performance presentation issues faced by the investment management profession. AIMR held a day-long training session on the standards for the SEC's New York regional office enforcement staff in 1994. The enforcement staff is interested in understanding the PPS to determine whether firms are being truthful when they claim compliance with the standards. If a firm claims compliance but is not in compliance, that firm, whether it is or is not registered with the SEC, violates the antifraud provisions of the U.s. Investment Advisors Act. AIMR is working with the SEC's Washington, D.c., staff to schedule a similar training session. In Canada, AIMR has met with every provincial securities commission to inform them of the PPS and to offer assistance in training their staffs about the standards. As a practical matter, a firm is less likely to be charged in Canada with violating securities laws for improper representation of compliance than would be the case under SEC jurisdiction because the provincial securities commissions' inspection programs of Canadian investment advisors are typically not as broad as the SEC's program.

Current Issues To refine, expand, or enhance the PPS, a number of issues have been recently resolved; others are in various stages of study. The primary topics of recent attention by the AIMR Performance Presentation Standards Implementation Committee (PPSIC), which is responsible for interpreting the standards and recommending changes when needed, are international compliance, taxable accounts, leverage/derivative securities, and venture and private placements. The two main topics currently being addressed by the PPSIC are verification and wrapfee programs. International compliance. The standards became effective on a global basis on January 1, 1994. The main issue the PPSIC international subcommit-

tee faced was how a multinational money management firm could claim compliance, which must be done on a firmwide basis. Consider the example of a global investment management firm with Japanese accounts. Certain Japanese accounts cannot be in compliance with the PPS because they are required by Japanese law to use book rather than market values. The international subcommittee, whose membership spanned eight countries, addressed this problem by redefining "the firm." According to the standards, a firm can be defined either as a separate legal entity (a separately incorporated and SEC-registered office in New York for a Swiss-based firm, for example) or a division that holds itself out to the public as a separate entity. The international subcommittee broadened the definition of a firm to include all accounts that trade in the same base currency. Taxable accounts. Another major issue recently addressed is the reporting of taxable accounts. The main concerns relate to the appropriate tax rate to be used for performance reporting and to the unfairness of penalizing a manager for trades performed for tax reasons. The reporting of gross-of-tax performance is currently recommended. The main advantage of a manager presenting gross-of-tax results is that prospective clients with taxable assets can then estimate after-tax results based on tax rates that are appropriate to their individual circumstances. Gross-of-tax results also avoid the complexities of presenting after-tax performance in a meaningful and comparable manner-eomplexities that arise because of current limitations in accounting and performance systems. The main disadvantage of reporting gross-of-tax performance is that it does not show how successful a manager has been in applying an investment style to a specific client. Different investment strategies will have different after-tax returns to investors that, over time, can significantly lower the clients' returns because of the compounding effect. For example, even if pretax performance is the same, an income-oriented investment style will have lower after-tax performance than a capitalpreservation style if capital gains taxes are less than income taxes. To address these problems, a PPSIC subcommittee on taxable portfolios issued a detailed report soliciting comments on its proposed approach to reporting performance on an after-tax basis. If aftertax performance is to be presented, some minimum requirements apply. First, the maximum federal tax rate for the type of client is to be used. Second, if a composite holds both taxable and after-tax portfolios, taxable securities must be adjusted to an aftertax basis rather than tax-exempt securities being

grossed up to a taxable equivalent. Third, taxes must be subtracted from the account no matter how and from what source they are paid. The subcommittee hopes to receive comments about the report from the profession and hopes that the report will raise the interest of systems vendors in addressing the needs of taxable portfolios. In addition, AIMR has been in contact with numerous organizations that provide benchmarks to determine interest in establishing after-tax benchmarks. Morningstar appears to be at the forefront in this area because of its work related to mutual funds. Leverage/derivative securities. The subcommittee dealing with performance reporting for leverage and/or derivative securities issued a clarifying report in April 1994. The requirements and recommendations for disclosure depend on the degree of discretion a manager has to leverage the portfolio through the use of derivatives or through margin. If a manager has full discretion, the manager is recommended to present both leveraged and unleveraged returns to current clients. The manager is required to report to potential clients the unleveraged return, disclose whether results are leveraged (and if so, the amount of leverage), and include the leveraged performance as supplemental material. The amount of firm assets to be included in the required statistical disclosure-that is, the percentage of firm assets under management-is the unleveraged amount. The leveraged amount of assets must be reported separately. If the manager does not have full discretion-if a client requires a manager to leverage by a stated percentage-the portfolio return must be calculated on the fully leveraged position and total firm assets must be based on the fully leveraged amount of assets. Venture and private placements. The subcommittee dealing with venture-capital investments and private placements released a report in April 1994 that describes how the PPS apply to these alternative investments. The report provides a detailed description and rationale for the presentation requirements. For applying the standards to these investments, the report draws a distinction between two levels of investment management: One level comprises general partners and fund-raisers, and the other level, intermediaries and investment advisors (which includes funds of funds). The report requires general partners and fundraisers to report a cumulative internal rate of return net of fees, expenses, and carry costs to the limited partners since inception of the fund. Intermediaries and advisors must also report an IRR net of the same fees applicable to general partners but gross of investment advisory fees, unless a regulatory authority 119

requires a net-of-fees performance. Composites must be defined by vintage year-year of a fund's formation and first takedown of capital. Verification. Verification of compliance is the most frequently raised concern about the standards. The purpose of adding verification to the standards was to create a mechanism to assure the client who relies on the standards that the performance numbers are truly presented in accordance with the standards. The PPSIC created a subcommittee, which includes three representatives selected by the American Institute of Certified Public Accountants (AICPA), to address verification. The verification subcommittee expects to publish a report clarifying numerous issues and uncertainties surrounding verification. The report has been approved, in principle, by the PPSIC and the Investment Companies Committee of the AICPA. AIMR recognizes that the standards created a cottage industry in compliance verification that now begs for the imposition of some consistency in scope of verifications and some kind of oversight-perhaps a body for "verifying the verifiers." The verification subcommittee report will thus include fairly detailed guidelines as to the minimum steps a verifier must follow when carrying out verification. It should level the playing field among verifiers and assist managers and their clients in standardizing the steps verifiers must follow. The report will address the scope of Level I and Level II verifications. Level I verification, which applies to the firm, will not change. It will continue to require that the verifier attest that all fee-paying discretionary accounts are included in one or more composites and that the composites are appropriately created. Level II verification, which applies to an individual composite and is similar to an audit that examines both the investment management process and the measurement of performance, will be modified to require only an abbreviated Level I approach. In the modified Level II verification, the verifier will be required to verify only that the composite that is receiving the Level II verification is appropriately created, that no other fee-paying discretionary accounts exist that should be included in the composite, and that all other fee-paying discretionary accounts are included in at least one composite. The verifier will no longer be required to take the additional step of determining that all manager composites are appropriately created. Firmwide compliance will continue to be required, but the subcommittee report will recommend that a Level I verification be requested only if a manager or a client wants the assurance that all composites are appropriately created.

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Finally, the report will provide model requestfor-proposal (RFP) questions that plan sponsors and consultants will be able to use to determine whether a manager is supplying performance numbers that are verified to be compliant with the standards. Wrap-fee programs. The second most controversial issue currently being addressed is performance reporting in relation to wrap-fee programs. A PPSIC wrap-fee subcommittee that includes one representative of the Investment Management Consultants Association and two SEC staff observers is drafting a report that addresses this controversy. The standards currently state that wrap-fee performance may be reported gross of fees only if transaction costs are deducted from the performance. Estimated transaction costs are not permitted. If the transaction costs cannot be determined, then the manager is required to report wrap-fee performance net of all fees, including the total wrap fee. The problem with the standard as currently stated is that if a manager has 90 percent of accounts in compliance, for example, and 10 percent in wrap-fee programs that are not in compliance, the entire firm is considered not in compliance. The wrap-fee subcommittee is likely to recommend that wrap-fee performance be reported on a "pure" gross-of-fees basis, whereby transaction costs are not deducted from performance as long as performance is also shown on a net-of-all-fees basis (that is, after deducting the total wrap fee). Other specific questions this subcommittee is addressing are: Should wrap-fee accounts and nonwrap-fee accounts be included in the same composite? Must gross-of-fees performance be shown at all times together with net-of-fees performance? Can non-wrap-fee accounts that are converted to wrapfee accounts be linked? Other issues. AIMR is working with the SEC to deal with reporting gross-of-fees performance of mutual funds that are included in a composite that contains separate accounts. In the controversial answer to Question #33 of the AIMR PPS Questions and Answers pamphlet, AIMR took the position that mutual fund performance must be reported net of fees at all times. This requirement, given only after discussion with SEC staff, created an outcry in the industry. AIMR then discussed the issue further with the SEC staff, which is reluctant to alter its position. AIMR will continue its discussions with the SEC staff on this and other issues concerning the presentation of mutual fund performance and advisor-subadvisor relationships. In addition, the SEC has contacted AIMR to clarify the standard that recommends gross-of-fees performance "unless otherwise required by the SEC." The SEC permits gross-of-fee performance reporting

only in a one-on-one presentation. AIMR will address this issue in an upcoming question and answer article in the AIMR Newsletter.

The Future Several concerns raised by the profession remain to be addressed. Some in the industry contend that verification needs further clarification, that compliance is too expensive, and that the standards are too institutionally focused. Others observe that limited enforcement capability and the firmwide compliance requirement both work to hinder acceptance of the standards. Some believe that equal-weighted composites should be used instead of dollar-weighted composites. AIMR recognizes that controversy still surrounds the standards, and the controversy will likely continue. The Bank Administration Institute performance measurement calculations issued in 1969 took nine years to implement and are still, after 25 years, somewhat controversial. AIMR intends to continue to focus on the concerns noted here and other issues as they arise. AIMR also intends to continue educational efforts with plan sponsors and consultants. Plans are being made for meetings with public and corporate plan sponsors in major cities to increase their familiarity with and understanding of the standards. AIMR will also continue its dialogues with the Investment Counselors Association and the American Bankers Association to address small-firm and bank compliance issues. In short, AIMR is committed to continuous improvement in its educational efforts regarding the standards, for the betterment of the profession and the good of its clients.

The Plan Sponsor Perspective J. Paul Dokas, CFA Bell Atlantic is among the more than 300 endorsers of the AIMR Performance Presentation Standards. We consider the standards a positive step in strengthening the integrity and credibility of the industry, and we encourage their continued development and implementation.

Benefits for the Sponsor Implementation of the standards has provided a number of benefits to plan sponsors and their ultimate clients. The primary benefit is a basic standard of comparison. Instead of spending a great deal of time going through details to find comparable performance numbers (e.g., gross return to gross return) when evaluating products, if the investment managers are complying with the standards, sponsors can easily make apples-to-apples comparisons and de-

cide whether further analysis is necessary. The standards provide a much greater level of transparency to performance results than existed previously. Some of the most important issues addressed by the PPS requirements and recommended, or guideline, disclosures concern the development of performance composites by an investment firm. Application of the PPS requirements limits a manager's ability to disclose performance results selectively. For example, a manager cannot"cherry-pick" accounts to show as a representative account one that may have performed better than other accounts. The PPS requirements call for all discretionary client accounts to be included in at least one of the firm's composites. In addition, the PPS requirements outline the methods for handling the inclusion of new accounts and the elimination of terminated accounts from the firm's composites to minimize the impact of such activity on the composites. The PPS also address the issue of simulated or model performance results. Saying that all backtests are fraudulent is too strong, but simulations can be very misleading. Sponsors want to be able to distinguish what information represents actual, realized returns and what represents simulated results. The PPS requirements state that a firm's composites must include only actual assets under management. Model results can be presented as supplementary information, but the model results must be identified as such and must not be linked to actual results. Another PPS requirement concerning the calculation of a firm's performance composite involves the inclusion of cash and cash equivalents in composite returns. A common problem without such standards is the reporting of an account's performance that does not reflect results for all the assets under management in that account. For example, the performance of an equity account might show the equity-only results, but the account might have held some level of cash, and during rising markets, that cash position would be a drag on performance; so, by showing equity-only results for that account, performance is made to look better than it actually is. The investment industry is characterized by a great deal of personnel movement, and long track records can be made up of a manager's performance history at several different firms-which often becomes an issue in disclosing performance results. Can a portfolio manager's investment results be moved from firm to firm? According to the standards, if an individual has been the principal involved in developing a performance record at another firm, that record can be displayed as supplemental information with the appropriate disclosures. The new firm, however, cannot link its performance history with that of another firm. The 121

guiding principle is that performance is the record of updating the standards and is working toward imthe firm, not of the individual. provements in a number of areas. The two aspects that have received much attention recently and conThe current PPS requirements call for managers to market-weight or capitalization-weight individtinue to be prospects for future enhancement are ual accounts when calculating a performance comventure capital and real estate. Common problems in posite. Depending on the specific facts in each both these areas include not only valuation methodsituation, one or the other mayor may not be the ologies but leverage and structural issues. These asappropriate choice, and much debate centers on pects are more challenging for nontraditional whether equal weighting or market-value weighting securities, from the standpoint of presentation stanis more appropriate. In a market-value-weighting dards, than for portfolios composed of traditional situation, for example, one very large account that securities. Because most of the nontraditional assets performs much better than the rest of the accounts in are illiquid and pricing is based on appraisals, an the composite will positively skew the composite interesting enhancement to the guidelines for these result. The PPS guidelines recommend, but do not securities would involve the disclosure of some type require, that an equal-weighted composite be calcuof metrics that would allow an investor to evaluate lated. Making the equal-weighted composite calcuthe quality of the valuations. lation a requirement would improve the standards. Another recommendation, or guideline, in the PPS involves the calculation of some type of disper- The Investment Manager Perspective Edward P. Rennie, CFA sion statistic for the composite return calculations. Typically, an analyst will want to examine the standInvestment managers for Pacific Investment Manard deviation or variance of individual account reagement Company (PIMCO) have always had a simturns around the composite return. For example, if ple objective: to be proactive with clients on any the composite return was 10 percent, a plan sponsor major issue. PIMCO's adherence to that objective is will be interested in knowing whether the range of illustrated in its attitude toward using and disclosing returns for accounts included in the composite was 0 its use of derivative securities and in its approach to percent to 20 percent or 9 percent to 11 percent. AIMR's Performance Presentation Standards. Requiring the calculation of this type of internal risk measure would strengthen the PPS. Derivatives One major benefit of the standards is that they PIMCO has used derivatives in a wide variety of help make transparent the impact of fees on returns. strategies for many years. The strategies are based on Fees are becoming much more important in the 1990s sound investment principles. A $4.5 billion equity than they were in the 1980s as total rates of return strategy using only derivatives has worked very regress toward lower absolute levels in line with well. In early 1994, however, when all the bombs long-term averages. With performance results disstarted falling on derivatives, PIMCO faced a choice: played on a gross-of-fee basis, as recommended, and Should we maintain a low profile and hope the dethe required disclosures of the manager's fee schedrivatives crisis goes away, or should we develop an ule, plan sponsors and investors can evaluate the information base for coverage with our clients? We impact of fees on net results better than in the past. chose the latter course because of our goal to be The standards also benefit sponsors by recomproactive. mending that, for comparative purposes, investment That course of action required much time and managers provide return information on a bencheffort. Our first step was to assemble a mailing to mark that is comparable in style or risk with the clients, which consisted of important written and composite. Clearly, this area leaves a great deal of graphic material. Because we wanted to explain the discretion to managers, but the guideline is meaningfirm's thoughts and actions fully, the materials deful because the spirit of the standards is to ensure the scribed why and how PIMCO uses derivatives, what comparison of like things-a small-cap equity acderivatives are used, the risks, and how the risks are count with a small-cap equity index, for example, or controlled. The mailings were then augmented by a long-duration bond account with a long-duration face-to-face visits with clients to give them the opporbond index. tunity to ask questions. PIMCO suffered little repercussion from clients Future Improvements about the performance of our portfolios with derivaAlthough the benefits of the standards are many, tives; therefore, we believe that although we can some areas exist in which improvement could ennever dispel all client fears, our efforts to communihance the quality of the standards. As Michael Caccate proactively helped make clients comfortable cese discussed, AIMR has recognized the need for with the firm's strategies. 122

PPS Strategy Pimco adopted a similarly proactive stance when the Performance Presentation Standards were proposed. PIMCO believed that clients would be asking whether we would use the standards. Therefore, we set out to analyze for ourselves the appropriateness of the standards and what would be involved in implementing them. We believed that presentation standards would be good for the industry. In addition, we knew that PIMCO's historically sound performance results would look good under any reasonable set of reporting standards. When the standards were issued, PIMCO further decided that they did not impose any serious constraints or limitations on the firm. Therefore, the firm made a commitment to adopt the standards. Our implementation process was straightforward; we could easily identify what needed to be done. We assembled small teams of portfolio managers, account managers, and programmers, and the implementation was carried out in a very timely manner; the process was neither terribly time consuming nor costly. In truth, the project was not con-

sidered a major undertaking, simply one of the important tasks that are required from time to time to remain a state-of-the-art firm in the investment industry. Once compliance is built into mechanized systems, compliance is automatic and completely painless. PIMCO's use of the standards is now routine. Compliance with the PPS benefits the profession. The investment management business today is extremely challenging, and many serious issues demand investment professionals' attention. Compliance with the PPS is one of the easiest issues: To be in compliance is the only way to do business. For example, the lifeblood of this industry from a marketing standpoint is the famous (or infamous) RFP. Every RFP PIMCO now receives asks if our performance numbers conform to the AIMR standards. Who would want to answer negatively to that question? Full disclosure is part of PIMCO's straightforward approach to investment management. Meeting the requirements set by the standards is part of the way PIMCO does business.

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Question and Answer Session Michael S. Caccese J. Paul Dokas, CFA Edward P. Rennie, CFA Question: In ongoing firm composites, how should one handle changes in account styles?

Caccese: Once a composite is created, the manager is required to ensure that the composite remains appropriately designed and includes accounts that should be in it. Therefore, a manager has an ongoing responsibility to monitor composites. If an account changes style, you can take that account out and put it in a different composite. The standards also give you the ability, when appropriate and depending on styles, to have the same account in two different composites. Question: Can an account that receives a significant cash inflow be excluded from a compositefor example, if a client with a $100 million account invests another $50 million in the account and several months are needed to invest the cash?

Caccese: The standards do not require you to include an account in a composite right away. You have the flexibility to take time to shape that account so that it is consistent with the desired style. For example, if a manager receives an account that is holding stocks that the manager does not usually hold, the standards give the manager time to sell those stocks and reshape the portfolio so that it is consistent with the manager's style. Only then is the manager required to add the account into the appropriate composite. Whatever procedure you use, you must use it consistently each time the issue comes up. 124

Question: What has been the response to the PPS recommendations on reporting portfolio risk statistics, and what is AIMR doing to promote this aspect of the standards?

Caccese: AIMR is encouraging the reporting of portfolio risk; we do not know how many firms are following the recommendations. The SEC has approached AIMR about developing some type of risk-based performance measurements that are responsive to portfolio changes, and AIMR is considering assembling a group of members to address the issues surrounding risk-based performance measurement. Question: Does AIMR maintain a list of recommended software systems for performance reporting?

caccese: AIMR maintains a list of managers that profess to have software that complies with the standards. AIMR does not verify the accuracy of the claims. Question: Is AIMR aware of any firms that claim compliance but in reality do not comply? If so, what actions does AIMR take?

Caccese: Six written complaints alleging false compliance claims on the part of firms that employ AIMR members have been filed with AIMR. All six claims were filed by competitors. An informal investigation of two of the claims revealed that no violations had occurred. We are still gathering information about the other four complaints.

Question: What is the danger that investment management is going to become overregulated by the standards?

Dokas: We began from a position of virtually no guidance or oversight, so we have a long way to go before we are in jeopardy of becoming overregulated. Rennie: I don't see regulation as a real problem. Although the PPS are a form of regulation, they are not at all onerous or illogical. In addition, with AIMR and others continuing to use their skills and experience to make enlightened improvements to investment management standards in general, overregulation is far down on my list of things to worry about. Question: What are the qualifications to become a verifier of AIMR standards as an independent third party?

caccese:

The standards list no requirements to become a verifier, which has raised concern about "fly-by-night verifiers." A client seeking to hire a verifier does not know the verifiers' skills or capabilities, track records, or verification processes. The guidelines for minimum steps in verification that the verification subcommittee is developing will give some comfort to both managers and clients that everybody who is carrying out verification is at least starting from the same base. Question: AIMR recommends reporting results gross of fees,

and the SEC staff recommends net of fees; could you clarify the issues involved?

Caccese: The SEC staff took the position in the Clover Capital No Action Letter in the late 1980s that gross-of-fees performance may be misleading because the client never actually receives that outcome. Philosophically, the writers of the PPS believed that the gross-of-fees basis is the more appropriate way of complying with the standards. As a result of much negotiation by the Investment Company Institute, the Securities Industry Association, the Institute of Chartered Financial Analysts,

and the Financial Analysts Federation, the SEC created an exception: If a manager presents performance in a one-on-one presentation, the manager can do so on a gross-of-fees basis as long as the manager includes its fee table with the presentation, along with other required disclosures. If the presentation is not on a one-on-one basis, however-for example, if it is in a general advertisement-it must be reported on a net-of-fees basis. Question: Are mutual funds addressed within the AIMR standards? Can they be included in composites (gross or

net)? Can a mutual fund alone make up a composite (gross or net)?

Caccese: Mutual funds, commingled funds, or unit trusts may be treated as separate composites or be combined with other portfolios or assets of similar strategies. The performance of portfolios invested in one commingled fund, mutual fund, or unit trust should be represented by the performance of the fund or unit trust. For portfolios invested in more than one fund or unit trust, a total return must also be calculated and performance included in a multiple-asset composite.

125

Measuring More than Performance Numbers Charles B. Burkhart, Jr. President Investment Counseling, Inc.

Several qualitative and quantitative operating measures are available to assess the health of an investment management firm. Studies of operating performance, compensation levels, and other indicators reveal both similarities and differences between US. and Canadian firms.

Some numbers, although not directly related to indexes or investment performance, are nonetheless important to and indicative of the overall health of an investment management firm. These critical numbers assess firm health both quantitatively (margins, compensation, and growth in revenues, assets, and expenses) and qualitatively (business and succession planning). Both aspects of firm health are vitally important to three constituencies: fund sponsors, who should go beyond performance measurement and performance attribution if they wish to do a good job of analyzing managers; funds that are planning to start in-house asset management companies; and the professionals in money management firms who want a framework for rating and measuring themselves that goes beyond investment performance. Measurement of firm performance is discussed here in the context of trends in the investment management industry. The presentation provides the results of studies of operating performance and compensation levels in the United States and Canada, and outlines important qualitative dimensions to evaluating investment firms' likelihood of future success.

Industry Trends Major current developments in the investment management business include accelerating consolidation and commoditization, the aging of independent firms, the decision to pursue multiple markets with multiple products versus pursuit of a niche strategy, and the emphasis on relationships versus products. Consolidation of the investment management business in North America is a fact of life, and with it comes increasing commoditization in all three major business segments-mutual fund, institutional,

126

and private client. The trends are much more rapid in the United States than in Canada but are accelerating in the latter market. The trends are also more rapid for mutual funds than for firms serving the institutional market or private clients, such as bank trust departments. The mutual fund business is highly commoditized; price competition is increasing, and size is becoming a critical factor in competition. A recent Goldman, Sachs and Company report speculates that no mutual fund under $10 billion in assets will be able to survive long term. 1 This assessment may be extreme, but competition, especially on price, is intense and increasing for funds that are trying to establish brokerage relationships on the bases of wrap-fee or other managed-account structures. The institutional business is not changing quite as much as the mutual fund business because the former is highly fragmented in the United States (and somewhat so in Canada). For example, probably 18,000 registered investment advisors exist in the United States, and only about 400 of them manage more than $1 billion in assets. A $500 million firm netting $2.5 million in fees and generating $1 million or more in compensation for its founder does not yet feel the impact of competitive pressure or necessary reinvestment. Most have not yet sensed they are in the midst of a revolution. A reduction in the number of managers institutional investors employ is, however, increasing the commoditization of the institutional business. Many managers are complaining that the sponsors with whom they work are paring down their manager lineups from, say, 40 to 20 managers, and they want to know if they will be among those cut or among 1 The Changing Economics of the Mutual Fund Industry, Goldman, Sachs and Company Industry Resource Group (May 1994):3.

those chosen to do more business with the sponsors. viving and can continue to do so. Doing business is becoming increasingly difficult and expensive for Either way, these managers are placed in a more these small firms, however. Historically, they have competitive mode by this kind of sponsor strategy. not had to reinvest in their businesses because they The private-client business is the most amorworked primarily with defined-benefit plans. Now, phous segment of the investment management busithey will have to do so to finance, for example, their ness and the most difficult about which to acquire mutual fund or defined-contribution-plan strategies. competitive information. This segment will probably Data show that serving mutual funds and definednot feel the effects of consolidation as quickly as the contribution plans requires more reinvestment than other two business segments because so many facpursuing the defined-benefit business. Moreover, tions exist in the business-from large bank trust the greater capital intensity of the mutual fund and departments to the brokerage side of the business to defined-contribution businesses suggests that the firms with divisions specializing in private clients. scale of reinvestment may be daunting for the niche The approaches of such firms as Trust Company of firms. The key issue for these firms is to decide where the West and Sanford C. Bernstein are completely they want to direct their businesses and focus their different from those of Northern Trust or U.s. Trust. business strategies. Their cultures, account minimums, and compensaAnother response to competitive forces is "instition practices diverge widely. tutional relationship trending," which refers to Another aspect of today's investment managemoves by a number of u.s. and Canadian firms to ment business is the aging of the independent firms. build more comprehensive and secure relationships Many investment management firms, especially in with their clients than has traditionally been the case. the United States, were started in the 1960s and 1970s Even at the potential cost of lower realized fees, firms by principals who were then in their 20s to 40s but will aggressively pursue market share, especially in who are now in their 50s, 60s, or 70s. They may not the markets with the slowest growth. Institutional have capitalized their firms, and they cannot sell to relationship trending is different from simply offertheir younger employees because the latter simply ing a stable of disconnected products. Firms pursucannot afford to buy in. Therefore, the owners of ing this approach are integrating their marketing, hundreds of American firms are facing questions investment management, and client services. For any about what to do for the second generation. Should company that plans to grow significantly-eertainly they work out "sweat equity" arrangements with on the institutional side-this approach of compreemployees? Should they sell their firms to the emhensive, professionally served relationships is absoployees at a discount? Should they sell outside to lutely vital. strategic or financial buyers? One result of increasing consolidation, commoditization, and competition is an increase in the Operating Performance of Investment number and scope of multiproduct/multimarket Management Firms firms. Investment management firms of all sizes are searching for ways to deliver more products to more Some guidelines for measuring an investment manmarkets from the same resource base in order to agement firm's financial health are provided by an offset the cyclicalities experienced by all firms. For examination of average firm performance. Table 1 example, a firm working with defined-benefit penshows key benchmarks in the form of 1992-93 aversion plans may seek to enter the defined-contribuage profit margins and growth in pretax earnings, tion or private-client and wrap markets. revenues, assets, and expenses for a universe of 25 of Many firms trying to expand in this way are the most dominant institutional firms in the United managing a few billion dollars in assets and subStates. Dominance was determined by net new busiscribe to the idea that expansion equals success in the ness, perceived reputation, size, and clout, and Table investment management business. This strategy is 1 shows the firms segmented into percentiles. The not appropriate for and should not be embraced by benchmarks used in Table 1 reflect what should be all firms, however. Many firms should think about key concerns from a sponsor's perspective; in an retrenching rather than expanding. Even some mulenvironment of shrinking market share and growing tibillion dollar firms should concentrate on refocuscompetition, measures of growth and efficiency ining their people, their current lines of distribution, dicate the degree of manager competence and the and their product lines. Rather than aspiring to grow presence or absence of good business planning. from $5 billion to $10 billion or higher, these firms The performance numbers relating to earnings should, given the industry trends, concentrate on are very impressive for this universe of top firms. Pretax earnings growth was more than 30 percent for managing what they have efficiently and effectively. Well-managed niche or boutique firms are surthe top half of the universe and never lower than 13 127

Table 1. Key Performance Benchmarks by Percentile Ranking: Universe of Dominant 25 U.S. Institutional Firms, 1992-93 Measure Pretax earnings growth Revenue growth Asset growth Expense growth Average profit margin

1st Percentile

25th Percentile

50th Percentile

75th Percentile

100th Percentile

Average

Median

50.0% 58.8 135.5 74.8 73.1

46.8% 33.3 32.0 30.8 61.0

30.8% 24.3 19.1 22.0 50.0

23.8% 19.6 12.2 16.8 33.7

13.5% 14.3 3.3 0.1 23.5

31.0% 26.3 28.8 24.7 47.1

30.8% 22.3 22.9 21.4 45.0

Source: Investment Counseling.

percent. Profit margins were strong: The normalized 1992-93 average profit margin for the midpoint of this universe (the 50th percentile) was 50 percent, and the lowest profit margin was 23 percent. A similar study of 13 Canadian investment management companies recently completed by Investment Counseling (ICI) found an average profit margin of about 33 percent. Table 1 indicates a revenue growth of about 24 percent a year for the midpoint of the universe; revenue growth for the midpoint of the Canadian firms was about 10 percent a year. Expense growth was notably higher for the U.S. firms, reflecting a more competitive and sophisticated infrastructure. Asset growth was far more dispersed than revenue growth for these firms. The midpoint was about 19 percent; for the Canadian firms, it was 5 percent. An important point is that these dominant firms have a median asset growth of 22.9 percent. ICI believes that medium-sized firms (generally defined as $5$20 billion in managed assets) that cannot grow at 10 percent a year (as measured by net new business and additional contributions) will probably be restructured or out of business within 15 years. Firms with extended poor performance in their only product offering have already eroded beyond critical mass.

Efficiency A key concern from the sponsor's point of view is the efficiency of an investment management organization. With that concern in mind, Table 2 presents various employee and productivity data gathered from the lCI study of Canadian firms. The largest firm was about US$14 billion and the smallest, about US$500 million in assets under management. The table summarizes numbers of employees and high, low, and average revenue and asset productivity ratios by functional areas. The "investment professionals" are primarily portfolio managers; the ratio of total professionals to total employees averages 66 percent. This ratio is lower in U.S. firms because they typically have more support staff than Canadian firms. As would be expected, the number of portfolio managers, marketing professionals, and secretarial!clerical employees in a firm is closely

128

correlated with size of assets under management. Revenues and assets per employee, however, do not increase uniformly as size increases. These ratios are two of the most important for measuring a firm's likelihood of future success, but the idea that as a firm grows in size an increasingly larger portion of each dollar flows to the bottom line is something of a myth. When a firm is growing largely because of additions to existing business, expenses will not keep pace with revenues and the firm will benefit from economies of scale. In today's multibusiness paradigm, however, a firm that has served only definedbenefit plans may need to add services and products for the mutual fund or private-client markets. In that case, growth in expenses may well parallel or even exceed revenue growth. Table 1 reinforces this conclusion; for the large, dominant firms reported in the table, average growth in expenses was 24.7 percent, in assets was 28.8 percent, and in revenues, 26.3 percent.

Delegation When an investment management company is showing poor margins or poor growth, or has stagnated for some time, one way to determine possible causes is to analyze how the five or six key people at the firm spend their time. Table 3, also from the Canadian study, shows the average reported amounts of time spent in various tasks. The table shows the chairs and the president/chief executive officers spending almost a quarter of their time on marketing/ client services. This focus would be expected for small firms (a few billion or less in managed assets), but as firms try to realize economies of scale in serving big businesses, this responsibility should be given to others. If a firm cannot develop some kind of marketing or client-service effort that will remove some of the load from the key founders of the company, that firm is not going to grow. Most of the other numbers are as one might expect, except that chief investment officers also are spending nearly a quarter of their time on marketing/client services. The important mix of roles performed by chief financial or chief operating officers is interesting, in that such positions were rare in the

Table 2. Employee Ratios and Organizational Structure: Universe of 13 Canadian Firms, 1992-93 Criteria

Average

Median

High

Low

Number of:

Investment professionals Marketing professionals Total professionals Total employees

13 3 20 36

14 5 21 29

27 16 50 114

6 1 9 12

$ 575 1,726 341 206

$ 365 1,356 234 179

$1,220 4,044 712 349

$241 895 160 120

321 1,235 194 127

316 863 209 131

509 4,265 297 194

92 308 61 46

Revenue ($thousands) per:

Investment professionals Marketing professionals Total professionals Total employees Assets ($millions) per:

Investment professionals Marketing professionals Total professionals Total employees

Note: This chart reflects 8 of 12 firms that supplied both employee and financial information. Source: Investment Counseling.

investment management business until five or six years ago. As firms began to understand themselves as businesses that needed to be run as businesses, the number of, importance of, and demand for those chief financial officers increased dramatically. Table 3 also suggests that the chairs are not figureheads at most of these Canadian firms; they are active in three or four parts of the business. These firms are relatively large, and as part of the growth process, their officers need to determine what the key people do best and where the key people should spend their time. When growth occurs, the officers need to recognize infrastructure changes to become more efficient, or the firm will flounder; that the chairs continue to undertake multiple tasks indicates that this process of delegation may not have occurred. Hiring is a related problem. In small firms or poorly run large firms, new employees often find that their jobs are only loosely described and that their responsibilities overlap with others. Sometimes, firms try to hire (and retain) key people to assume chief financial or chief investment officer positions but the firms do not have a model in place by which they can explain the new employees' roles.

Client Services and Marketing A striking aspect of the U.s. study of 25 dominant institutional firms involves differences between firms that separate and those that combine client services and marketing responsibilities: Of the universe in that study, 71 percent worked through a combined client-service/ sales/ marketing approach. Table 4 shows that new business growth and additional contributions accounted for slightly more than 42 percent of overall asset growth between 1992 and

1993 for firms with separate departments versus about 21 percent for firms that combine the two areas. Fund performance fueled approximately 7 percent of the asset growth in both approaches; plan terminations and fund withdrawals accounted for about 12 percent negative growth in the separate functional approach and about 3 percent negative growth in the combined case. The combined sales and service approach seems to be the most effective approach in terms of retaining business. The large split in favor of a combined approach reflects the reality that separate departments are a luxury most small firms cannot afford. As firms become bigger, they tend to create client-service or product liaison groups that use their skills very specifically to service all different facets of their clientele's needs. The client-service people, as one might expect, are often not paid the formula-based incentives that the marketing people are paid. As suggested by Table 4, separating service and marketing responsibilities has proved to be a tremendous catalyst for asset growth for firms that can take advantage of their economies of scale; the overall change in asset growth from 1992 to 1993 was about 14 percentage points higher for firms with separate marketing and client-service responsibilities than for firms with a combined function. Should portfolio managers have a minor or a significant role in client service and marketing? Table 5 illustrates portfolio managers' involvement in the marketing process of the 25 firms in the U.s. study. "Low involvement" in the study meant little client contact, rare attendance at meetings, and a hands-off stance in general with respect to clients. "High involvement" meant frequent participation in 129

accounts and additional contributions than those in which portfolio managers are not as involved. Overall, the asset-change figures for both groups are similar. The active involvement of portfolio managers has been a catalyst for many firms, but the extent to which that involvement occurs and is beneficial depends a great deal on firm size. To be successful, portfolio manager involvement must be combined with a separate client-service unit. Many client-service managers today at leading firms are former portfolio managers who hold CFA designations. They are not sales people; they are strong, technically sound investment managers. Data such as those presented in Tables 4 and 5 should also persuade investment management firm personnel to think flexibly about their career paths. Portfolio managers may well become involved at some point in selling and servicing. Depending on the nature of a firm's clientele, the firm may retain combined roles in the future, but increased segregation and specialization within a given role seems likely. Separation of responsibilities addresses client-service issues more effectively than a combined approach, and client service is the most important response to the three Cs-eonsolidation, commoditization, and competition-occurring in the industry.

Table 3. Average Percent of Key Executives' Time Allocated by Responsibility: Universe of 13 Canadian Finns, 1992-93 Chair Management of company Investment policy / asset allocation Portfolio management Marketing/client services Administration Operations

38%

31 5 22

2 2

Presidentlchiefexecutive officer Management of company Investment policy/ asset allocation Portfolio management Marketing/client services Administration Operations

34 23

14 24

4 3

Chiefjinanciallchiefoperating officer Management of company Investment policy / asset allocation Portfolio management Marketing/client services Administration Operations

22 1

1 14 34 28

Chief investment officer Management of company Investment policy / asset allocation Portfolio management Marketing/ client services Administration Operations

10 38

33

20

o o

Director of marketing Management of company Investment policy / asset allocation Portfolio management Marketing/client services Administration Operations

4

8 3

Compensation

72 7 7

Note: Numbers will not equal 100 percent because they represent averages in each category. Source: Investment Counseling.

both the initial and final stages of the marketing process. High-involvement managers will see clients and prospects whenever possible. Table 5 shows that firms in which portfolio managers are highly involved in the marketing process generated more new

Whenever compensation figures are offered, identifying the context of those figures with respect to firm size and type is critical. Table 6 reports a study of portfolio manager compensation at 40 small, independent boutiques in the United States. The top panel is sorted by quartiles of total compensation; the bottom panel, by quartiles of average assets under management. The firms manage anywhere between $100 million and $3-$4 billion; most are under $1 billion. Average total compensation in the first quartile is $318,000 and declines to $45,000 in the fourth quartile. The largest rift in portfolio manager pay is

Table 4. Contributions to Asset Growth from Separate versus Combined Market and Client-Service Responsibilities: Top 25 Institutional U.S. Firms, 1992-93

Asset Change New accounts Additional contributions Performance Terminations Withdrawals Total change

Source: Investment Counseling.

130

Separate Marketing and Client-Service Responsibility 33.4% 9.2 7.1

Combined Marketing and Client-Service Responsibility

-6.1

18.7% 2.4 6.9 -2.4

::5A

::!l2

38.2%

24.7%

Table 5. Contributions to Change in Assets from Low versus High Involvement of Portfolio Managers in Marketing Process: Top 25 Institutional U.S. Firms, 1992-93 Asset Change New accounts Additional contributions Performance Terminations Withdrawals Total change

Low Involvement

High Involvement

18.8% 3.6 8.8 -3.2 -1.1 26.9%

27.1% 5.4 5.7 -3.9 ::aA 30.9%

Source: Investment Counseling.

between firms managing on either side of $1 billion in assets. A range of firms by size will always show this kind of fragmentation, and compensation levels of in-house fund managers are often lower than even this group of relatively small firms, which are probably the lowest in the U.s. investment management community. The real problem for in-house fund managers, however, is the lack of opportunity. Even in these boutique firms, salary represents at least 2/3 of compensation in every quartile, and the ratio would be higher for strictly in-house managers. In either case, little bonus or equity opportunity exists. Salary as a percentage of total compensation should always be relatively small for the highest paid people in the business. Among the best firms in the business, salary percentage is perhaps 10-20 percent. Average compensation in these 40 small firms, however, would not be expected to reach that kind of percentage; Table 6 confirms that expectation and indicates a direct correlation between compensation and asset size. Table 7 reports a study of the compensation of senior portfolio managers on the domestic equity side in 12 large U.s. investment management firms. Three firms in this study had senior equity portfolio managers receiving cash compensation of more than

$1 million. When those three are excluded, average and median cash compensation is approximately $500,000 and is almost evenly split between base salary and bonus. A comparison of the average total compensation given in Table 7, $1.036 million, with the $318,000 average of the first quartile in Table 6 illustrates how compensation figures can easily be inappropriately compared. As total compensation increases for these firms, salary becomes a consistently smaller percentage of the total, and the highend portfolio managers' total cash compensation is so high that it would almost have to include some ownership or dividends. This observation points to a difficulty in any compensation study-determining the amount of real bonus, whether it is earned on a subjective or formula basis (rather than against a benchmark), and how much of it is dividend or ownership share. In examining salary numbers, using the correct universe is important. As the bottom panel of Table 7 shows, the salary of the lowest paid person in these 12 dominant U.S. firms is nevertheless higher than the first-quintile average shown in Table 6. The important aspect of measuring salaries and total compensation is to compare a firm with its reasonable competition. If the firm is not competing against bank trust departments for personnel, comparing the firm's salaries with bank trust salaries makes no sense. Table 8 shows compensation data for sales and marketing personnel for the same 40 U.s. boutiques reported in Table 6. As shown in the bottom panel, small asset size typically means low compensation. Average total compensation shows the biggest increase as firms cross the $1 billion level of assets. Salaries ranged up to $250,000, but more than 90 percent were $100,000 or less. The more highly paid a staff member, the smaller the percentage of total pay from salary. To relate these compensation levels to productivity, lei estimates that U.S. marketers should produce three times their pay in total produc-

Table 6. Portfolio Manager Compensation: Universe of 40 Small U.S. Firms, 1992-93 (U.S dollars in thousands) Quartile

Average Salary

Average Total Compensation

Range of Total Compensation

Salary as a Percent of Total Compensation

A. Sorted by quartiles of total compensation

W

~~

~W

Q2 Q3 Q4

94 61 40

135 81 45

$177-$1,301 108-165 60-106 25-59

66% 70 76 90

B. Sorted by quartiles ofassets under management Ql ($2,279) $137 $215 Q2 ($632) 56 103 73 102 Q3 ($345) 73 Q4 ($139) 64

$40--$1,301 25-255 40--178 40--120

76% 67 74 88

Source: Investment Counseling.

131

Table 7. Compensation Composition: Senior Portfolio Managers Managing Domestic Equity: Universe of 12 Large U.S. Firms, 1992-93 (U.S. dollars in thousands) A. Total sample

Base Salary

Level Average Median Low High

$255 220 146 450

Base Salary as Percent of Cash Compensation 38.4% 33.3 6.7 94.1

Subjective Bonus $332 261 25 900

Subjective Bonus as Percent of Cash Compensation 46.46% 54.3 5.9 66.7

Total Cash Compensation $1,036 581 380 3,000

B. By percentile

Components Base salary Total cash compensation Base salary (percent of total cash compensation)

100th Percentile

75th Percentile

$ 450 3,000

$ 325 1,675

15.0%

19.4%

50th Percentile $220 581 37.9%

25th Percentile $200 494

1st Percentile $146 380

40.5%

38.4%

Source: Investment Counseling.

tion annually to justify these subjective bonus levels. This figure represents a benchmark for the better performing marketers in the United States, but lCI has not been able to formulate a similar benchmark in Canada. Compensation figures for Canadian marketing personnel are much lower than in the United States, reflecting the lack of industry recognition of marketing professionals in Canada. Recent Canadian studies show that some marketing people-not support personnel but full-fledged marketing professionals-are paid a base salary of only US$30,OOOUS$40,000 and receive subjective bonuses of no more than US$5,OOO-US$1O,000. Most of the sales/marketing people included in Table 8 were paid by formula-based incentive programs, which currently prevail in 70-80 percent of the U.S. industry. This percentage is declining, however, as subjective issues and team performance become

increasingly important. Depending on the size of the business, formula-based compensation can provide huge commissions to the marketers. Therefore, medium-size and large firms (those of $5-$10 billion and above) are finding that justifying the formulabased approach is difficult because the sales task is increasingly complex, sophisticated, and service oriented. Portfolio managers are often involved, for example, but if they are receiving subjective bonuses, they are paid nothing for their marketing efforts. One way to overcome these problems is to institute a marketing compensation pool, perhaps 25-30 percent of new business revenue. The person who actually closes the sale would receive a guaranteed percentage or a range of the total percentage, 15 percent for example, and the rest of the people in the group associated with the sale would divide the other 10-15 percent. This approach is designed to engender loyalty among all those contributing to the

Table 8. SaleslMarketing Compensation: Universe of 40 Small U.S. Firms, 1992-93 (U.S. dollars in thousands) Quartile

Average Salary

Average Total Compensation

A. Sorted by quartiles of total compensation Ql $103 $256 Q2 92 128 ~

00

W

C

$176-$440 95-174 69-93 23-61

B. Sorted by quartiles ofassets under management Ql ($2,279) $86 $173 66 104 Q2 ($632) 54 106 Q3 ($345) 76 Q4 ($139) 76

$23-$440 30-235 40-208 40-150

~ ~

Source: Investment Counseling.

132

Range of Total Compensation

Salary as Percent of Total Compensation 42% 75 87 94 66% 74 59 100

marketing effort and to focus the attention of all parties on the relationship between the marketing corps and the new business. Fairness in rewarding client-service and marketing people should be an issue for sponsors; unfair compensation to marketers will result in high turnover and a serious threat to the progress and survival of the management firm. Marketing has the highest rate of turnover in the business. One key to retaining marketing people is the level of compensation potential, and the other is the existence of long-term opportunity with a firm. Providing long-term opportunity is the area where many firms fall short. Compensation for senior client-service professionals in the 12 large US. firms is reported in Table 9. If these figures are to be compared with those for small firms, the context must be kept clear. In the small firms, people tend to occupy dual roles-they are marketers and client-service personnel-because those firms can rarely afford to split the tasks. Therefore, this analysis considers only senior client-service professionals in the large-firm group, for whom compensation generally includes a subjective (rarely formula-based) bonus. Their average total cash compensation, $476,000, was significantly greater than that of the high end of the first quartile of sales/marketing personnel in Table 8, which was $256,000. This difference reflects the substantial pay differential by asset size and firm economics.

Qualitative Evaluation Investment management firms should consider some important qualitative factors in their selfevaluations, and sponsors should also examine these factors in comparing firms. The worth of these firms cannot be judged by using some kind of discounted cash flow analysis based solely on the numbers and rules of thumb often found in leading investment management publications, such as three to four times revenue and six to seven times pretax earnings. Second-generation motivation. This factor pertains to whether the business is organized for and has

provided for succession or is a proprietorship. A proprietorship has an entirely different set of efficiency ratios, often has a whole different idea about compensation (the founder or the key people take it all), and, just as often, has no idea what the firm is going to look like two or three years from now. Any firm and any fund sponsor trying to figure out whether the firm will have low professional turnover and be modestly successful in the next few years must determine whether the important next generation of professionals who are running the firm now are being given the opportunity to develop their abilities and a stake in the firm. Second-generation motivation is certainly lacking in many US. and Canadian firms today.

Understanding of the client and consultant perspectives. Investment managers often do not understand the client and consultant perspectives. Some managers pay external parties a great deal of money to determine the consultant or the client perspectives on their firms. This task could probably be more easily and efficiently achieved, however, by the inhouse marketing crew. The "star" factor. Having a star in a firm is, at first, a catalyst for excitement and success, but then it can become a debilitating influence. Stars have precipitated the rise of many a prominent boutique in the United States, but if they did not provide for second-generation motivation, the stars also more than likely caused their firms' fall. Momentum. This factor includes asset, revenue, and earnings growth; professional development; product diversification as it affects performance; and infrastructure capacity. Sponsors are obviously interested in the firm's ability to sustain reinvestment, but those 52 percent or 60 percent pretax profit margins and that firm value of two to four times revenue are not sufficient. Sponsors want to know where management firms are going in terms of their asset, revenue, and expense growth. Operating performance and the momentum depicted by trends in performance are as important as investment performance. To discover the directions of

Table 9. Compensation Composition: Senior Client-Service Professionals, Universe of 12 Large U.S. Firms, 1992-93 (U.S. dollars in thousands)

Level

Base Salary

Average Median Low High

$196 200 150 225

Base Salary as Percent of Cash Compensation

49.5% 33.3 28.3 100.0

Subjective Bonus

$280 300 0 519

Subjective Bonus as Percent of Cash Total Cash Compensation Compensation

50.5% 66.7 0.0 71.7

$476 450 225 724

Source: Investment Counseling.

133

growth, sponsors need to study at least three years cycle, and it is important to sponsors, to those thinkof operating data; that is a long enough time for most ing of buying or selling a firm, to employees, and to measures to indicate a firm's direction. potential employees. Where is the firm going? Has it Professional development of the people in a firm hit the top of the growth curve and is now either is part of building for the next generation. Sponsors tumbling or drifting down, or is it still growing? Is want to know who they are hiring-not just today, senior management relatively young? but for tomorrow's needs as well. Considering this sort of timing is a major element One aspect of the study of the 25 dominant instiwhen a sponsor or individual is considering a move. tutional firms in the United States was to determine A firm may have great numbers today, but simply whether asset-class and product diversification had applying a few screens may show that the numbers anything to do with asset growth, revenue growth, will not look nearly as good in a year. and margins. The study came to a very distinct conThe same approach is useful for firms in analyzclusion: Firms that concentrate on a narrow set of ing whether the time has come to acquire or to sell. asset classes (two or fewer asset classes) and, at the The current merger and acquisition market is frensame time, have broad product offerings within the zied; as of November, the year 1994 (78 transactions) classes (more than two products in each asset class) had surpassed 1993 (66 transactions) as the busiest have by far the best efficiency ratios. Part of the M&A market in the industry's history. Probably 30reason is that the larger, more mature firms have 40 buyers exist for every seller; so, the market is achieved higher margins than most small competing overwhelmingly a seller's market. firms. At the same time, those large firms have recognized the increasing competition for existing products like defined-benefit plans and recognized Conclusion the importance of growth; they realize that a 40 percent profit margin on $40 billion in assets is prefFrom the fund sponsor who is interviewing or meeterable to a 60 percent profit margin on $10 billion. ing the leading officers of an investment manageThis finding indicates that firms can become too ment firm to the young employees looking up at diverse and too extended-to the detriment of their those officers, the firm's opportunities and its potenprofit margins. tial predicaments are important elements of valuMomentum may depend on the firm's infraation. How is the firm now coping with industry structure capacity. Excess capacity, when a firm is competitiveness, and more importantly, is it poised managing $1 billion and could easily manage $2 or to sustain or achieve success in the future? Under$3 billion with no professional hires, is a good sign. standing industry trends, developing a knowledge Firms that are hard-pressed to manage their $1 bilof operating performance and compensation levels, lion in assets should be devalued in any valuation. and recognizing important qualitative evaluation Timing. This factor pertains to evaluating factors should contribute to answering these queswhere the investment management firm is in its life tions.

134

Question and Answer Session Charles B. Burkhart, Jr. Question: Why do firms need to grow their assets by 10 percent a year? Burkhart: The 10 percent growth number is applicable to only the small and medium-sized firms, firms that are typically $20 or $30 billion or under, which is the huge majority of firms. The number is based on our expectations of market potential for many of these firms, on how tough it will be to string together 12,14, or 16 percent compoundgrowth performance, and on how difficult the institutional business is going to be in terms of the three Cs and actually maintaining one's business. I think 10 percent-5 percent from new accounts and additional contributions and 5 percent from fund performanceis a moderate benchmark for determining whether a firm will survive and grow materially beyond its current asset level or whether it will start shrinking. Many firms in the United States and Canada are shrinking. Question: Why did you give a figure of 5 percent asset growth

for Canadian firms? Burkhart: The Canadian 5 percent was based on a 13-firm sample representing the average asset growth for those firms in the last two years. The number needed for future growth may be somewhat higher or lower than 5 percent but is, in any case, lower than the benchmark for US. firms. The Canadian market is mature but less competitive than the US. market, and the Canadian firms have not been as active as U.S. firms in marketing or client service. The ones that will be the leaders in the current consolidation will grow at rates much higher than 5 percent, and the mediocre firms will grow at lower rates. Question: When two firms combine, what is the percentage of assets or percentage of client accounts lost in the merger? Burkhart: The answer depends on the circumstances. The investment management business is a people business; if the people don't come, the assets rarely follow. So, if the merger is in

friendly circumstances-in our business, it almost has to be-and if it is a combination of two whole businesses, 80-90 percent of assets may transfer into the new entity. Some 10-20 percent of the assets may go elsewhere. If some part of one of the firms is not merging, those assets will stay with the people who are not going over to the newly merged entity. Question: Are the profit margins currently being achieved sustainable in a more competitive world? Burkhart: No, indeed. Margins are going down. We have been studying them for six years, and the days of easily generating 4050 percent normalized pretax margins are over. Everything I discussed is pushing margins down for most firms. Some firms will take advantage of the competitive factors and be able to keep their margins up, even increase them, but the vast majority will experience declining margins and revenue growth.

135

Evaluation of Major Decisions Affecting the Pension Plan ThomasJ. Cowhey, CFA Executive Director, Trust Asset Management Bell Atlantic Corporation

Fiduciaries have an ongoing responsibility to evaluate the nature of plan returns and the quality of investment decisions. Assessment of plan performance is enhanced by focusing on the plan's policy portfolio, the benchmarks used, and the costs incurred.

Pension plan sponsors have fiduciary responsibilities to manage and monitor plans. In response, this presentation presents an approach for evaluating plan sponsors' overall management of pension funds. The focus of the approach is on plan performance relative to the plan's policy portfolio, individual asset-class benchmarks, and management costs.

Plan Performance and Policy Portfolios Suppose an independent auditor has been retained to conduct an audit of a plan sponsor's management of its overall pension fund. The audit begins with a meeting between the auditor and the sponsor in which the sponsor outlines the plan's investment process. The sponsor first talks about setting investment objectives and how the asset allocation policy is established. The sponsor then describes the investment strategy for each asset class, including what percentage of the fund is actively (or passively) managed, what percentage of the fund is internally (or externally) managed, what investment styles are used in the equity asset classes, and what the investment guidelines are for the various managers. Finally, the sponsor describes the monitoring of the pension fund's management. As the discussion concludes, the plan sponsor displays a performance chart that shows how well the fund has done versus other funds in a peer universe during the past one, three, and five years. This chart, Figure 1, shows that the plan (return indicated by solid circles) has outperformed the median fund in the universe (indicated by the cross-bars in each box) in all periods. The sponsor indicates that the individual asset classes also achieved good results. The auditor's initial conclusions might be that

136

this fund has performed well, that it appears to have a reasonable investment approach, and that appropriate controls seem to be in place. Suppose, however, that the auditor decides to probe further. The auditor recalls some analysis done by a firm called Cost Effectiveness Measurement showing that, during a four-year period, when pension funds' actual returns were regressed against the returns of the funds' policy portfolios-that is, passive portfolios constructed to reflect the funds' asset allocation policies-on average, about 35 percent of the variance in the pension funds' returns could be explained by policy differences. 1 Therefore, although the plan sponsor seems to compare well with the peer universe, the auditor asks the sponsor to construct a policy portfolio for the fund and measure actual returns against that policy portfolio to obtain a clear picture of the impact of the fund's asset allocation on the results. Comparison of the fund's performance with the policy portfolio still indicates favorable results for the fund, but this approach finds a lower implementation return (excess return over the policy portfolio) than did the comparison with the median plan. Therefore, the auditor decides that more can be learned about the source of the returns by investigating how other pension funds have performed in relation to their policy portfolios. In this comparison, as Table 1 shows, during the 1991-93 period, the implementation returns for all funds were found to be, on average, about 140 basis points (bps) a year more than their policy portfolios. Therefore, although this plan sponsor has outper1 "The Economics of Pension Fund Management," The Ambachtsheer Letter (October 5, 1994).

Figure 1. Total Fund Investment Performance: Example 13 12

11 10 9

~ 8

~ 7

~

6

1: ~

3

2 1

o -1 -2 1 Year

3 Year

5 Year

Source: Frank Russell Company.

formed the policy portfolio, the outperformance was mix around the policy mix. All of the value added in implementation return appears to have come from consistent only with the average of other funds for in-asset-class investment decision making, which apthe period. pears to have generated the return at fairly high At this point, the auditor decides to examine the levels of statistical confidence. sources of performance for the peer group to see why or how the typical fund managed to average 140 bps a year in excess return over its policy index. Table 1 Plan Performance and Benchmarks shows the return broken down into two components. The auditor's analysis so far indicates that the plan One component is the portion that can be attribsponsor is adding value primarily by generating a utable to varying the asset allocation mix around the return within asset classes in excess of the benchpolicy portfolio objectives. For example, if the policy marks for those classes. Indeed, the sponsor organiobjective for large U.S. equities was 40 percent, the zation states that the fund is performing well versus fund managers might have allowed the fund mix the benchmarks used in the various asset classes. The during some period to go from 35 percent to 45 sponsor's U.S. equity portfolio uses the S&P 500 percent and back again. This component of impleIndex as the benchmark, and the auditor confirms mentation return measures how much return those that the sponsor has outperformed that benchmark variations generated for the fund. The second comfairly well during the past two or three years. The ponent, in-asset-class return, focuses on fund return international equity portfolio uses the MSCI EAFE relative to the benchmark return for the asset classIndex as its benchmark, which it appears to have that is, how much return was earned from the deoutperformed reasonably well during the past couployment of active management in the asset class. ple of years. The figures in Table 1 suggest that these funds Given the importance of the benchmarks in asgenerated little, if any, return by varying the asset sessing the sponsor's apparent superior performance, however, the auditor raises the following Table 1. Fund Implementation Returns questions: How difficult is outperforming these 1991 1992 Return 1993 benchmarks, and how good are the benchmarks? In asset class

Varying asset allocation mix Total

1.6% (4.8)

1.1% (5.5)

1.9% (8.1)

-D.4

0.3

-D.3

lli)

G:§)

1.2 (3.3)

1.4 (6.9)

(-2.0) 1.6 (7.1)

Note: Figures in parentheses are t-statistics. Source: Cost Effectiveness Measurement.

Domestic Benchmark Misspecification One way of examining the appropriateness of domestic equity benchmarks is shown in Table 2. The table lists 13 BARRA risk factors and uses as a base index the exposures to those factors of an approximately 1,200-stock universe. It then shows the exposure to those factors for the S&P 500 and a 137

Table 2. Benchmark Misspecification with the S&P SOOlndex

Risk Factor Success Variability in markets Growth Earnings variation Earnings / price Book/price Yield Size Small capitalization Trading activity Labor intensity Foreign income Financial leverage

S&P 500 -0.06 -0.13 -0.11 -0.05 0.02 -0.02 0.08 0.34 0.00 -0.01 -0.03 0.15 0.04

Institutional Investment Manager Composite 0.12 0.26 0.23 0.19 0.04 0.06 -0.28 -0.36 0.08 0.23 0.17 0.02 0.01

Source: Harris Bank.

Harris Bank composite of its U.S. institutional manager universe in relation to the BARRA index. For example, the figures for the size variable indicate that the capitalization of the S&P 500 is 34/lOOth of a standard deviation above the market-weighted average of all stocks in the universe. This 0.34 statistic means that the S&P 500 has a "largeness" bias relative to the entire universe. In contrast, the size figure for the institutional investment manager composite is 36/l00th of a standard deviation below the BARRA universe. Based on the composite results, U.s. equity investment managers appear to have a considerable "smallness" bias relative to the S&P 500. Plan sponsors, by hiring small-cap and large-cap managers and managing their portfolios with index funds, are able to adjust for these size biases. Then the question becomes: What benchmark does the institutional plan sponsor's portfolio look like? For this comparison, the auditor begins with market capitalizations. The S&P 500 is about $6 billion in terms of average market capitalization, whereas the Russell 3000 Index, a much broader universe than the S&P 500 and one that encompasses more of the overall stock market, is approximately $1.5 billion in average market capitalization. The median market capitalization for the typical pension fund in the Frank Russell Company client universe is $1.51 billion, which means that the median fund looks a lot more like the Russell 3000 than the S&P 500. What are the implications of these size variances over time? Figure 2 charts the performance of the Russell universe and the Russell 3000 in relation to the S&P 500 for rolling one-year periods during the 1985-94 time frame. The solid line charts the performance of the Russell universe, and the dotted line charts the performance of the Russell 3000. Outper138

formance of the S&P 500 by the Russell universe (Russell 3000 Index) is indicated when the solid (dotted) line is above the zero-excess-return horizontal line; underperformance is indicated when a return line falls below the zero line. The figure reveals several quarters when the Russell 3000 and the Russell universe of managers were outperforming the S&P 500 but also several periods when they were underperforming it by large amounts. The figure also shows that the Russell 3000 is highly correlated with the Russell universe; regressing the universe against the Russell 3000 explains 75 percent of the former's return variation. These findings have important implications for performance attribution. If a plan sponsor is using only the S&P 500 as a benchmark and if the actual portfolio has risk characteristics that more closely resemble the Russell 3000, the analysis of implementation return will not be accurate and faulty decisions may be made about management results. Using the correct benchmark-in this case, the Russell 3000leads to an interpretation of added value that is quite different from using the S&P 500, and a true judgment can be made about management decision making. Therefore, using the appropriate benchmark is critical when evaluating the success or appropriateness of active versus passive management.

International Benchmark Misspecification Benchmark selection involves important specification issues in the global arena as well as the domestic. As Table 3 indicates, one benchmark misspecification (illustrated by the EAFE Index in this case) is a weighting of Japan in the benchmark that is different from the weighting given by most portfolio managers. Japan is a large market with a large market capitalization. It represents more than 48 percent of the market capitalization of the cap-weighted EAFE Index, but a typical current manager has about 34 percent exposure to Japan. In addition, the typical active manager seeking to outperform the EAFE Index has about a 6 percent exposure to non-EAFE countries. If a sponsor does not take these kinds of differences into consideration, Table 3. Benchmark Misspecification: Country Weights for the EAFE Index and for the Median Manager Country

EAFE

Median

Japan United Kingdom Germany France Switzerland Non-EAFE

48.5% 14.5 6.0 5.4 4.5 0.0

34.0% 12.9 5.0 6.4 4.0 5.8

Source: Frank Russell Company.

Figure 2. Performance of the Russell 3000 Index and the Frank Russell Company Universe versus the S&P 500: Rolling One-Year Periods 0.06 0.04

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Ql Q3 Ql Q3 Ql Q3 Ql Q3 Ql Q3 Ql Q3 Ql Q3 Ql Q3 Ql Q3 Ql 85

86

87

88

89

90

91

92

93

94

Source: Frank Russell Company.

the sponsor's analysis of performance can be misleading.

Plan Performance and Costs The audit process to this point has analyzed the plan's policy portfolio, the extent to which the plan is generating implementation returns, and the potential need to make adjustments for both domestic and global benchmark deficiencies. An important remaining audit element is cost. How much money is the plan sponsor spending in pursuit of these returns? Is the fund a high- or low-cost operator? To answer these questions, the auditor first needs to gather detailed cost information: how much money the sponsor pays for staff, investment managers, trustee fees, consulting fees, and so on. These costs can be totaled and divided by the average assets under management to obtain an expense ratio. The auditor in our example follows this process and finds that the plan, which is a large plan, is in the top 20 percent in terms of management costs. On an absolute basis, it appears to be a high-cost plan, but the auditor decides to examine these costs further. Table 4 provides an analysis of factors that have been determined to have a significant impact on plan costs. It shows that operating costs relate negatively to the size of the plan, which makes sense because the larger the plan, the more economies are realized in terms of investment management fees and the spread of fixed costs across a large asset base. Costs go down with each incremental increase in plan size. Therefore, a $36 billion fund that appears to be much more cost efficient than a $100 million fund mayor may not be efficient once adjustments are made to reflect the impact of the size factor.

Table 4 also shows that plan costs vary directly with the size of the plan's allocations to equities. The higher the proportion of a plan in stocks, the higher the costs. Cost analyses should adjust for this relationship. If one plan decides to run an asset allocation of 60 percent stocks and another plan chooses to run a stock allocation of 40 percent, the plan with the larger stock exposure should not be penalized for having higher costs if the costs are commensurate with the typical costs for other plans following a high-equity policy. Differences in costs associated with differing asset allocation decisions are even more pronounced for real estate and nontraditional investments. Real estate, venture capital, and oil and gas limited partnerships are all higher-cost investment pursuits. Table 4. Fund Operating Costs by Characteristic (bps) Fund Characteristic

1990

1991

1992

1993

92 (13)

79 (10)

76 (10)

(10)

-22 (-12)

-20 (-11)

-19 (-12)

(-11)

Stock proportion

32 (4)

38 (5)

33 (4)

40 (6)

Real estate and nontraditional investments proportion

113 (6)

107 (5)

105 (5)

127 (7)

Canadian

-18 (-7)

-14 (-5)

-12 (-5)

-9 (-5)

Constant Size of plan (log)

72

-19

Nole: The numbers in parentheses are I-statistics. Source: Cost Effectiveness Measurement.

139

Cost analysis limited to the overall expense ratio Table 5. Fund Implementation Returns versus Operating Costs would penalize funds that pursue such investments even though the investments may, in fact, be contrib1990 1991 1991-93 1992 1993 uting higher implementation returns than other inConstant 1.7 0.62 0.96 0.71 0.72 vestments and, in the long run, will boost the fund's (8.2) (2.6) (4.7) (3.7) (4.1) overall expected return and diversification characteristics. Cost -0.03 0.01 0.0 0.03 0.06 (-2.0) (0.3) (-0.2) (4.2) (1.9) When the plan sponsor's costs are analyzed in this type of approach, what the auditor thought to be a very Note: The numbers in parentheses are t-statistics. high-cost pension fund actually appears to be a relaSource: Cost Effectiveness Measurement. tively low-cost fund. Adjustments for plan size and differences in asset allocation provide a completely earlier, however, and if the reported returns were different understanding of a fund's cost structure. adjusted for those deficiencies, the cost-return relaWith this information, the auditor can analyze tionship might be different. Therefore, further work the fund's costs relative to its investment decision needs to be done to refine these results. Nevertheless, making: How much return should be expected from the findings for the peer group and the analytical this fund in light of the amount of risk being taken process of adjusting a fund's results for benchmark beyond the policy portfolio's risk? Are the expenses deficiencies, strategies, and implementation decifor an active equity manager and/or to pursue an sions allow an auditor to reach more supportable implementation return by following certain assetperformance conclusions than otherwise. class strategies appropriate? Table 5 shows an analy_ sis of implementation returns versus operating costs during the 1990-93 period for the same universe of Conclusion funds used for Table 4. The coefficient on the cost Plan sponsors have a fiduciary responsibility to variable is 0.03 and positive, which means that for this period, for every 10 bps of expenditures, the monitor their own decision-making performance in universe was able to generate 30 bps of incremental light of the plan's performance. They must continually evaluate the nature of the fund's returns and the return. In short, during this period, the typical pension created value through its investment decision quality of investment decisions. They must ask themmaking. selves the tough questions about costs and results, These implementation returns were no doubt and they need to seek answers through the types of influenced by the benchmark deficiencies identified analysis discussed here.

140

Question and Answer Session Thomas J. Cowhey, CFA Question: How does Bell Atlantic decide on the amounts of assets to allocate to each manager? Cowhey: As an example, for the U.S. equity asset classes, we first decide how much residual risk we can take in the US. equity portfolio-that is, how much variation of return we can tolerate around our benchmark portfolio for US. equities, the Russell 3000. Then we allocate money between an index fund and a few active managers through an iterative process that achieves the optimal allocation-defined in terms of expected return relative to the amount of acceptable risk taken per unit of cost to be spent to pursue that expected return.

We follow this process for each asset class so that we are optimal in aggregate. The process is dynamic, however, and we monitor the relationships of active to passive to ensure that they remain optimal. A time may come, for example, when active fixedincome management offers a higher return per unit of risk and per unit of cost than other active portions of the portfolio, and we may want to rebalance the portfolio to take advantage of such an opportunity. Question: How does Bell Atlantic decide between internal and external management? Cowhey:

We have not reached

a final conclusion on this issue. We began the type of analysis reported here a few years ago, and we are constantly seeking to improve in cost-effectiveness. We have used index funds and negotiations with investment managers to drive our investment management costs down. These actions and the competitiveness in the industry have helped us achieve significant cost benefits without the need to take the next step to internal management. We might decide to take that step in the future, but before doing so, we would need to assess the benefit side of the issue and ensure that we can put the administrative tools, people, and resources in place to be successful.

141

Hiring and Firing an Investment Manager Keith P. Ambachtsheer President KP.A. Advisory SeNices Ltd.

Hiring and firing investment managers have traditionally been carried out by an inductive approach. A deductive approach, however, may be preferable. A deductive approach draws on a different set of manager search questions to identify and hire successful managers-and to fire unsuccessful ones.

Finding, hiring, and keeping active investment managers that have better than a 50-50 chance of adding value requires more than knowledge of individual investment management firms and their historical performance. It requires a priori beliefs about the characteristics of successful investment management firms and a sound manager search strategy.

The Market for Investment Management Services A retail market and a wholesale market exist for investment management services. The retail market includes mutual funds, 401(k) plans in the United States, group Registered Retirement Savings Plans in Canada, and high-net-worth individuals. In the wholesale market, the primary purchasers of investment management services are defined-benefit pension plans. The wholesale market has been dominant throughout the past 20 years and is the primary subject of this presentation. Aggregate defined-benefit assets in the United States total approximately US$3 trillion, and the corresponding Canadian asset base is approximately C$300 billion, which supports the usual United States-Canada ratio rule of 10 to 1 in almost anything measured.

Pension Funds as Businesses The focus of K.P.A. Advisory Services since its founding in 1984 has been on understanding the motivations and the economics of pension fund management. A useful approach to refining that understanding has been the development of a business

142

paradigm for considering the fundamental issues that surround pension fund management. Thinking of fund management as a business makes certain issues clear. For example, considering pension fund management as a business suggests that two fundamental strategic issues confront the business. One concerns the funding of pension plans, and the other concerns investment policy. Ideally, the two should be jointly determined. What is more germane to this discussion is the business issue that follows the determination of investment policy: How should that investment policy be implemented? Fundamentally, two implementation choices exist. One focuses on the legal necessity to have and to invest pension assets; it involves a "satisficing" posture. The fund wants to get the job done by keeping a low profile and fulfilling its fiduciary responsibility while spending as little money as possible. The approach is to generate a return in the most reliable, dependable, cost-effective way possible. The policy return is, in this strategy, simply a function of policy risk and cost. The alternative choice is to go beyond the legal minimum and view the assets as an opportunity to make money. This approach seeks to generate additional return, with the implication that additional risk and costs will be incurred. Most pension funds opt for the alternative of seeking incremental returns. The challenge then becomes how to implement the decision, which triggers a need to develop information about the costs and benefits of the decision. The fund needs to keep track of its policy return, incremental return, cost to implement the policy, and additional expenses incurred to produce the additional return.

A Business Information System for Pension Funds The essence of the business issue is incremental returns-the notion of producing value for the fund. One way to examine value production is to look at actual returns against calculated policy returns, the ?ifference being the value added by actively managmg the fund. The value added can then be examined in light of the operating costs needed to achieve the returns. Figure 1 reports profiles by implementation returns and incremental operating costs for 76 pension funds from 1991 through 1993 in the Cost Effectiveness Measurement (CEM) data base that have a three-year continuous history.1 The funds, nearly all corporate or public, were mostly multibillion dollar funds with multiple external managers whose average mandates were in the US$100-US$300 million range. Figure 1. Implementation Retums versus Incremental Operating Costs for Funds with Three-Year Histories, 1991-93 S

5

Q)

]

co

4

c cco

3

0

;:l

~ Cfl

E ;:l

0 High Value Added/ High Cost

2-

The high-value-added/low-cost funds averaged 1.2 percent in implementation returns and -6 basis points (bps) in incremental operating costs, and the high-value-added/high-cost funds averaged 1.7 percent in returns and +7 bps in costs. The low-valueadded/low-cost funds returned -1.0 percent on average, with average incremental costs of -8 bps, and the low-value-added/high-cost funds averaged -0.7 percent returns and +9 bps in costs. Figure 1 supports the business decision to pursue incremental returns: Active management produced significant incremental returns for these funds during this three-year period. Extra expenses produced extra returns. Note, however, that how much value is added by active management obviously depends on the benchmarks used for comparison. For example, if the fund uses a broad investment strategy that mcludes small-capitalization stocks and then uses the S&P 500 Index as the only benchmark, measured incremental returns will vary from one scenario to the next depending on how small-cap stocks perform. Thus, these findings must be interpreted with caution. A matrix such as Figure 1 allows a fund to evaluate its business decision to pursue active management by considering whether the incremental returns are sufficient to justify the incremental expenses. If that question is answered ~ffirmatively,a successful manager search strategy IS necessary.

~c O O 0 .~ 0 ~----U-O~On«O)-C,+\f(}d..}-------~ -M----Se--h--------------

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Low Value Added/ 0 Low Cost 0 00

-20

0

0 0

0

0

-----L

o

anager

0 Low Value Added/ High Cost

----L_ _~

20

40

Incremental Operating Cost (basis points)

Source: Cost Effectiveness Measurement.

The value added by a fund is captured on the vertical axis of Figure 1. The full operating costs of running a fund-both direct investment management and governance and administrative costsare captured on the horizontal. CEM has generated benchmark costs based on fund size and asset mix that are used to determine whether a fund's actual costs are higher or lower than benchmark costs. A fund's ~ncremental operating costs are primarily determmed by the degree to which the fund uses external and/ or active (high-cost) versus internal and/ or passive (low-cost) portfolio management. 1

For a more-detailed exposition of these findings, see Keith P: Ambachtsheer, "The Economics of Pension Fund Management," Fmanczal Analysts Journal (November I December 1994):21-31.

arc Strategy

How do fund spon;furs go about assuring themselves beforehand that the managers they hire have the prospects of adding value? Sponsors can follow either an inductive or a deductive approach to the task.

The Traditional Inductive Approach Most search processes still use an inductive approach; that is, they go from the specific to the general. The process begins with the sponsor finding all the high-performance managers, putting them on a list, and asking them a series of screening questions to narrow the list. These "requests for information" are very detailed and include questions about the people in the firm, the continuity of its employees' tenure, the capital structure of the firm, how the firm manages money (what is the firm's style), and whether the firm presents performance in line with the AIMR Performance Presentation Standards. The decision to fire is also generally straightforward. The standard rule is that a fund manager should be fired if the manager produces four years of poor investment results. 143

These traditional approaches to initiating and terminating investment management relationships should be questioned. The premise on which they are based may be wrong. Table 1 addresses this issue. Consider three possible scenarios for active managers. In each scenario, 1,000 active managers exist. In the first scenario, only good managers and bad managers exist and half of the group are good, half are bad; in the second scenario, only average managers exist; and in the third scenario, most managers (800) are average, but a few (100) are good, and a few (100) are bad. In Scenario I, the good managers have a .9 probability each year of beating their benchmarks (that is, having a positive-alpha, + a, year); the bad managers have a .1 probability of beating their benchmarks. In Scenario 2, all managers have a .5 probability of beating their benchmarks in any given year. In Scenario 3, the distinction between the good and the bad is no longer as severe as in Scenario 1; a good manager has a .6 probability of beating the benchmark in any given year, the average manager has a .5 probability, and the bad manager has a .4 probability. Thus, the probabilities of over- and underperformance are no longer massive, merely marginal. If Scenario 3 reflects reality, as most parties in the investment business doubtless believe, what are the implications for a search process? To help answer that question, Table 1 shows the probability, in all three scenarios, of active managers beating their benchmarks for five consecutive years. In Scenario I, 295 of the 500 good managers would be expected to have five good years in a row; none of the bad managers would be expected to meet that expectation. In Scenario 2, the probability is that 31 of the 1,000 managers will have five successive good years, despite the fact that the individual-manager chances are only .5 each year. In Scenario 3, 8 of the 100 good managers, 25 of the 800 average managers, and none of the 100 bad managers would be expected to have five successive years of positive alphas.

If Scenario 3 represents reality, how can the inductive approach be effective? A screen based on all the high-performing managers for a typical five-year period would identify 33 managers, 8 of which would be truly good and 25 of which would be average. The sponsor would interview many average managers that appear to be good, which would be defeating the purpose of the screen. So, perhaps the whole search strategy deserves rethinking.

The Deductive Approach A deductive approach may offer better prospects for success than the traditional inductive approach. It would begin by outlining the attributes of successful active management-what characteristics a manager would have to possess to be one of those in Scenario 3 with a .6 probability of positive excess return each year-and proceed to look for managers with those characteristics. Defining successful active management. What is known about successful active management that could be used in such a search strategy? A 1979 article by Ambachtsheer and Farrell identified four attributes of successful active management. 2 The first is an understanding that the process of active management can be decomposed into information processing, portfolio rebalancing, and learning components. The second attribute of successful active management is predictive ability about some aspect of the investment universe-be it markets, sectors, or individual securities. Third, that predictive ability must go beyond information content; it must be sufficient to overcome the cost of transaction. So, the active- management challenge involves balancing potentially low-quality forecasts against the certainty of transaction costs in adversarial markets and trying to squeeze out some net positive return-the essence of successful portfolio rebalanc2 Keith P. Ambachtsheer and James L. Farrell, Jr., "Can Active Management Add Value?" Financial Analysts Journal (November/December 1979):39-47.

Table 1. Probability of a Manager Beating the Benchmark Fund Manager Scenarios

Probability of One+ Year

Probability of Five+ Years

Actual Number of Managers

E(Numberof Five+ Years)

Scenario 1: Only good and bad managers exist. Good Bad

.9 .1

.590 .000

500 500

295

Scenario 2: Only average managers exist. Average

.5

.031

1,000

31

.6 .5

.078 .031 .001

100 800 100

8 25

Scenario 3: Good, average, and bad managers exist. Good Average Bad Source: K.P.A. Advisory Services.

144

.4

a

a

ing. Fourth, every portfolio management process needs explicit feedback on the accuracy of the predictions going into the process and on the efficacy of the rebalancing, and people need to learn from this feedback. Ambachtsheer and Farrell, using the Wells Fargo dividend discount model and Value Line momentum inputs, structured portfolios that beat the S&P 500 by 500 bps a year after transaction costs. The question is, of course, can such results be replicated in the "real world," where portfolios can be assembled and managed only through trading in adversarial securities markets? In the securities markets, the only way investment results are achieved is through a manager assembling an initial portfolio and then making portfolio changes by selling to and buying from other parties. If everyone is trying to do the same thingproduce a positive alpha after transaction costs-a profoundly adversarial situation arises. One party can win only if the other one loses. Every successful portfolio adjustment means that someone is making an unsuccessful portfolio adjustment. Treynor has suggested the analogy of a poker game: 3 Everyone is playing a hand (their portfolios); they are playing against other people, who are also trying to play their hands (their portfolios). Portfolio managers know their own portfolios, research, and judgments, but they do not know those of other players. Because in this game when one wins the other loses, ferreting out that information about one's adversary while concealing one's own is crucial to successful active management. If a manager knows more about his or her opponent than the opponent knows about the manager, on average, in their trades, the knowledgeable manager is likely to win and the opponent likely to lose. In about 500 B.C., the Chinese philosopher Suntzu (in The Art of War) described three possible wartime situations: knowing neither the enemy nor one's self, knowing one's self but not one's enemy, and knowing one's enemy as one knows one's self. Only the third kind of portfolio manager has a chance of being successful. Knowing one's self is fine, but it is not enough. A manager who does not know the opposition is a.5 (average) manager. Knowing when to play and when not to play is key, and this wisdom can come only from knowing one's opponents: knowing why one manager is losing when another particular manager is winning. Implications for the manager search. These insights into the game of active management have important implications for active-management search processes. As Perold and Salomon have noted, even if a manager's investment process is 3 Jack 1. Treynor, "The Economics of the Dealer Function," Financial Analysts Journal (November/December 1987):27-34.

successful, it will experience a decay function. 4 Every successful wealth-generating process has a size-related curve that, at some point, will peak and begin to deteriorate. That is, a successful active manager cannot enter the market with increasingly large blocks and maintain a constant probability of success. Figure 2 illustrates Perold and Salomon's point. Figure 2. Wealth-Maximizing Block Size with Linear Spreads 5.5 Ul

5.0

0.-

on '+-