"Many PMs are Closet-Indexers, Masquerading as Active Managers" (Neel Kashkari, PIMCO)

Neel Kashkari has written an interesting piece on active equity management, to point out some qualitative differences that exist in active management, and he also touches on the controversial subject in our education system of our teachers "Teaching to the Test" to make the point, eloquently. For those of us in Ontario, Canada, this is none other than the EQAO. Although it is a bit of a commercial for PIMCO's new equity division, it extends a full perspective/reasoning on what is both effective and ineffective within active portfolio management, and, our education system. At the very least, we thought it was worth reading.

Teaching to the Test

by Neel Kashkari, Head of Global Equities, PIMCO

• Many managers are focused on beating benchmarks, rather than helping clients achieve their investment objectives. Clients save and invest their money for specific reasons, such as for retirement or children’s education and managers should focus on helping them meet those goals.
• Many managers are really “closet indexers” masquerading as active managers while charging premium fees for benchmark returns. Many equity managers deviate very little from their benchmark because they are terrified of potentially underperforming it.
• All of our active equity strategies are unconstrained relative to typical equity strategies. We go anywhere across the globe looking for the best investment opportunities and the best risk-adjusted returns. We are not closet benchmarkers. We invest aggressively in our best ideas.

Most people agree America’s K-12 education system needs a lot of help. Too many students drop out of school, and too many of those who do finish graduate without proficiency in math, reading and science.
An intense debate is taking place among education policy experts as to the merits of rigorous academic testing to make sure students are on track, to identify and reward schools and teachers who are succeeding, and to identify and replace those who are failing. This is related to the mantra from management guru Peter Drucker, “If you can’t measure it, you can’t manage it.”

Critics of testing argue such quantitative assessments lead to unintended consequences. For example, they believe teachers are incentivized to “teach to the test,” which results in students who are able test takers but lacking in other social, cultural and interpersonal skills that are necessary for success in life.

I will reveal my bias: If our biggest educational challenge is that all of our students graduate from high school having successfully been “taught to the test” – Hallelujah! It will mean all of our students actually can read and actually have basic math and science skills. Even if they aren’t all budding creative writers, this is far better than the current state of American education.

Teaching to the test is helping China and India produce many talented students who are performing well in our best graduate schools – and going on to become successful entrepreneurs, doctors, engineers and scientists.

However, not all of the unintended consequences of rigorous academic testing are positive. Recent revelations that some teachers cheated by changing their students’ answers on tests are deeply troubling. This is worse than Bernie Madoff, who, in the analogy of “teach a man to fish…,” stole an awful lot of fish. Teachers who cheat their students are stealing their students’ fishing poles. They should be prosecuted to the fullest extent of the law. And if teachers cheating students isn’t breaking current law, Congress should pass a new law.

So what does this have to do with equity investing, you might ask yourself? There is a parallel to “teaching to the test” – it is “managing to the benchmark,” the traditional approach stubbornly adhered to by many equity managers. Contrary to the clear evidence of benefits of teaching to the test, in equity investing such positives are hard to find.

Many academic studies, as well as highly regarded industry figures such as index fund pioneer John Bogle, have argued that equity managers often struggle to beat equity indices, such as the S&P 500. They argue that investors should stop trying to beat the market, but instead just select the cheapest fund that tracks the benchmark.

In response to these findings, the active equity mutual fund industry has fundamentally restructured itself around an almost singular mission: to try to demonstrate that active management can, in fact, beat benchmark returns in order to justify charging premium fees for active stock selection. Regular measurement of equity fund performance against index returns has become the primary tool in proving managers’ worth.

Objectively assessing whether managers are earning their fees is a good thing – but, as with all measurements and incentives, there are often a number of unintended consequences. Let’s explore specific examples:

1) Many managers are focused on beating benchmarks, rather than helping clients achieve their investment objectives.

Success has now been defined as beating a benchmark. Managers are promoted and firms are rewarded when managers outperform the equity market in a given time period. But this framework loses focus on clients and their objectives. Clients save and invest their money for specific reasons, such as for retirement or children’s education.
Did a manager who lost 34% in 2008 while the S&P 500 fell 37% do a good job of protecting his client’s assets? Did he control risk effectively?
Managing to the benchmark would say, “Yes, job well done.” Common sense would say, “No.”

2) Many managers are really “closet indexers” masquerading as active managers while charging premium fees for benchmark returns.

Many equity managers deviate very little from their benchmark because they are terrified of potentially underperforming it. The stated thesis of most active equity managers is to dig deeper, to unearth investment opportunities that the market hasn’t yet appreciated. Managers try to get to know companies, their competitors, suppliers and customers better than other investors in order to determine who will do well, and avoid those who will do poorly. But many active equity funds have 150 or more individual stock holdings; some have 200 or more stocks.

Can a manager really understand the detailed business models and changing competitive positions of all 150 or 200 stocks in her portfolio? This is highly unlikely, if not impossible.

Hence, many managers are reducing their risk of underperforming their benchmarks by buying more and more stocks, and, as a result, knowing less and less about each of them. In doing so, they usually end up just tracking the benchmark – or even worse, lagging it – while still charging premium fees.

Some managers will only consider buying a stock if it is included in their benchmark. This artificially limits their hunting ground to the sparsest part of the market where the companies are best known by the most investors.

In a 2010 review of active equity mutual fund managers, Professor Antti Petajisto of Yale found “weak performance across all actively managed funds, with the average fund losing to its benchmark by –0.41%. The performance of closet indexers is predictably poor: They largely just match their benchmark index returns before fees, so after fees they lag behind their benchmarks by approximately the amount of their fees. The only group adding value to investors has been the most active stock pickers, which have beaten their benchmarks by 1.26% after fees and expenses.”

3) Risk has been redefined in terms of managers rather than clients.

Equity managers today often define “risk” relative to their benchmark. For example, healthcare makes up 12% of the S&P 500. A manager who has a healthcare allocation of 7% or 17% of his portfolio is said to be taking more active risk than one who has a 12% allocation, who is, in theory, taking no risk.

But is this really true? Are clients really more or less likely to achieve their investment goals, or more or less likely to lose money, because of a 7% or 17% healthcare allocation just because the benchmark happens to have 12%?

Or is that benchmark-centered framework designed to minimize the career risk of the manager? Certainly the 7% or 17% healthcare allocation will increase the tracking error for the fund relative to the S&P 500. That increases the likelihood that the manager will be deemed either a hero or goat at the end of the year. But what does it have to do with the risks clients are taking in achieving their investment objectives? Nothing.

4) Managers are rewarded for launching as many funds as possible.

Another unintended byproduct of managing to benchmarks is even more pernicious: the proliferation of mutual funds and mutual fund awards. In full disclosure, PIMCO has won many of these awards. But every year, thousands of awards are made to equity managers by prestigious firms largely based on recent performance delivered relative to benchmarks. For example, in 2010 Lipper granted over 1,500 awards globally (1,500!) for the best equity mutual funds based on relative performance.

This focus on managing to the benchmark incentivizes equity mutual fund firms to launch as many funds as possible, because at least a few are bound to win a few awards. Firms can then buy advertisements in the Wall Street Journal or USA Today declaring themselves a “Mutual Fund Award Winner.” Such a designation can have a powerful effect on potential clients who don’t realize that only a few of their funds won the awards; it provides a halo to the entire firm.

Why do the raters give out so many awards? Because those advertisements that highlight the winners don’t just help the fund managers, they also convey a level of stature to the firms granting the awards. It is a virtuous cycle of back-scratching between the fund managers and the awarding firms. Everyone wins, right? Everyone except for clients. Do these backward-looking awards indicate that clients actually achieved their investment objectives? Not always.

Managing to the benchmark has transformed much of the active equity industry away from helping clients achieve their objectives and toward helping fund managers achieve theirs. While “teaching to the test” aligns incentives between teacher and student, managing to the benchmark unfortunately can lead to an unhealthy divergence of incentives.

If managing to the benchmark is flawed, how should clients choose among hundreds of equity managers? For starters, clients should focus on those firms that have the best processes to deliver the desired outcomes. This isn’t easy. It requires work and diligence. But considering how hard clients have worked for their savings or retirement nest eggs, some diligence to decide with whom to invest is prudent.

Having entered the active equity industry later than others, PIMCO has had the opportunity to do a lot of basic questioning. As a result, we have developed a series of principles that guide how we invest in equities. And we believe clients will be better off using a framework such as this to decide where, how and with whom to invest:

1) Look at a portfolio in its entirety, rather than just by asset class, and focus on outcomes. What is the goal for this portfolio?

- We are focused on delivering investment solutions that meet our clients’ needs. We are increasingly offering multi-asset solutions that combine equities, fixed income and other asset classes in one offering.
- Many clients appropriately try to diversify across asset classes, but often they don’t realize that many asset classes are correlated.

We focus on risk factors rather than asset classes to help ensure portfolios are truly diversified and risks better understood.

2) Determine in which markets passive equity management makes sense, and in which markets active equity management is potentially better. For the index exposure, you may want to buy the fund or ETF with low fees. For the active exposure, choose the manager with the best investment framework.

- We believe U.S. equity markets, especially large caps, are quite efficient and it is hard to sustainably generate an edge. In this space, the academics and John Bogle are right. It makes sense to use low-cost index products for U.S.-only equity exposure, but selecting a smart benchmark is also important. Market cap–weighted benchmarks are simple but not necessarily smart.
- However, we believe global equity markets are less efficient and there is an opportunity to add value through careful active management where managers can invest across borders, geographies and sectors looking for the best opportunities.

Hence, all of PIMCO’s active equity strategies are global.

3) For the active management segment of an equity portfolio, actually actively manage the investments. Remove artificial constraints. Don’t hug the benchmark. Go anywhere to find the best opportunities and exploit them.

- All of our active equity strategies are unconstrained relative to typical equity strategies. We go anywhere across the globe looking for the best investment opportunities and the best risk-adjusted returns. We are not closet benchmarkers.

We invest aggressively in our best ideas.
- Our active equity portfolios are fairly concentrated relative to the approach taken by many other managers – between 50 and 100 stocks in a typical portfolio. Our equity investment process starts with rigorous individual company analysis. And our investment team knows each of the names we invest in exceptionally well. If we didn’t, it wouldn’t be in our portfolios.

4) Buy companies you want to own and evaluate them in the context of the economic environment in which they operate.

- At PIMCO we have a team of world-class equity investment professionals who tap into our firm’s macro process and global economic insights when evaluating individual equity investment opportunities.

We believe it takes both rigorous individual company analysis and a global macroeconomic framework to successfully manage global equity portfolios, and that’s how we’ve structured our equity investment process.

5) Invest for the long term.

- Given quarterly financial reporting, the 24-hour news cycle, and real-time social media, attention spans seem to be getting shorter and shorter. It is easy to become lost in the constant stream of events affecting global equity markets.

- Although we clearly pay attention to near-term market movements, which could create buying opportunities, we are much more focused on how near-term events affect our long-term outlook for the companies we like.

We are buying companies we like at attractive valuations that have strong fundamentals. We are patient investors. We tend to measure our equity holding periods in years, rather than months (or even days or minutes as some do).

6) Manage downside risk.

- As the financial crisis and recent market turmoil has reminded us all, market corrections can be swift, dramatic and can erase years of gains.
- Understanding how portfolios respond to unusual circumstances is critical to understanding risk and managing potential downside scenarios.

We stress test our equity portfolios against market shocks, and often actively embed “tail risk hedging” in the strategies themselves. While tail risk hedging isn’t free, we believe it can help reduce downside risk and help our clients achieve their investment objectives in a range of market environments.

As a society, we can and should aspire for every single one of our students to receive a good education and become proficient in reading, math and science. Education is not a zero-sum game: Knowledge can be shared widely to everyone’s benefit.

Benchmark-oriented investing, or managing to beat an average, however, is a zero-sum game. Everyone cannot outperform the market; by definition, half must outperform and half must underperform. Reorienting the way we think about equity investing, away from beating a benchmark and toward achieving clients’ objectives, will take time. We look forward to continuing to explore the global equity investment landscape with you in the coming months and years.

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