Investment Benchmarking: 2006 Equity Style Distributions


The critical importance of peer universe comparisons, and the significant insight of style universes, can be
illustrated with an example using 2006 equity portfolio results. Consider a particular equity manager’s disturbing performance in 2006:




Manager return: 9.4%

 

Equity market return: 15.7%

 

Relative performance: -6.3%

 

Over six percent below the benchmark certainly seems to be very poor performance. But how bad is it really? Should a manager change be considered? Unfortunately, simply comparing the manager’s performance to the market index does not provide enough information to assess whether or not a change is necessary.

Significant insight is gained when our manager’s return is compared to the returns of all other property-casualty equity portfolios. In this case, manager’s rank within equity universe: 6th percentile.

Now that we know 94 percent of all equity managers outperformed our manager, we have more reason for concern --- and further investigation.     

Poor performance relative to the equity universe may be further explained if the manager was hired with a specific style mandate and that style underperformed. Small-cap growth stocks underperformed in 2006. If our Manager is a small-cap growth manager, comparison to a small-cap growth index reveals:

 

Manager return: 9.4%

 

Russell 2000 Growth: 13.4%

 

Relative performance: - 5.0%

 

In this case, comparing performance to the appropriate style index explains only about one-third of the manager’s underperformance. Return five percent below the manager’s style index sounds like a serious problem. But how serious? Enough to take action? Again, comparison to a single data point does not provide sufficient information.

The final insight is added when we compare our manager’s return to the returns of all property-casualty small-cap growth portfolios. Manager’s rank within small-cap growth universe: 40th percentile.

Performance at the 40th percentile, while not favorable, is well within the bounds of random error and certainly does not suggest a reason to consider a change. On the other hand, if the manager had been a large-cap value manager, the same five percent underperformance in 2006 would rank at the 7th percentile and a manager change may be in order. Completely opposite inferences from the same performance relative to an index. Without peer universe data, however, this vital distinction would be lost.

The problem with limiting performance comparisons to indexes, including style indexes, is that either:

    1. Managers may be needlessly terminated, at significant cost; or,
    2. No action will ever be taken, in which case why evaluate performance in the first place.

Either way, comparing investment performance solely to market indexes is a meaningless exercise!

 

Effective benchmarking provides sufficient information to determine when corrective action is necessary.

Indexes are valuable components of the benchmarking process, but by themselves are not sufficient. Simple index comparisons lack the context required to draw meaningful conclusions.

Because indexes provide only a single comparative data point for each time period, it takes decades* to determine with any statistical meaning whether or not an investment manager has positive or negative skill. So by the time you have enough data to reach a conclusion, it's far too late.