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February 13, 2015 at 08:39 AM
The active managers at fund Grantham Mayo van Otterloo (GMO) are advising investors not to hastily fire active managers who have performed abysmally vis-à-vis their benchmarks in 2014.
No, they are not saying that GMO, best known as the hedge fund home of Jeremy Grantham, has underperformed. This is not personal.
Rather, two of GMO’s investment management executives, Neil Constable and Matt Kadnar, offer a novel explanation as to why active managers underperform — when they do underperform.
An understanding as to that reason may help suppress the desire to fire managers who may well outperform in the coming years, they say in a new GMO white paper called “Is Skill Dead?”
The timing of their paper stems from fresh data on 2014 suggesting that between 80% and 90% of U.S. active managers underperformed their benchmarks last year.
That large proportion, which is typical of manager performance on the up or downside, troubles Constable and Kadner, who contend that the results should be somewhere around 50-50 net of fees if active managers were pursuing independent strategies.
The pattern of herdlike performance suggests a specific cause influencing manager success or failure that goes beyond standard portfolio decisions in terms of sector biases or investment style since, they write, “for every active manager that is overweight a sector, there is another who is underweight.”
The systemic cause they propose lies in the propensity for U.S. managers to allocate a generally small portion of their portfolios to non-U.S. stocks, small-cap stocks and cash. “Underperformance in any of these will act as a drag on the performance of the overall portfolio,” they write, as in fact all three did vis-à-vis the S&P 500 in the 12 months ending last Sept. 30.
“If a manager were to have had 5% of his portfolio in non-U.S. stocks, 5% in small-/mid-cap U.S. stocks, and carried 1% in cash, then he will have effectively started with a deficit of 120 bps versus the benchmark. That is a lot of ground to make up from stock picking within the S&P 500 alone,” Constable and Kadner write.
The GMO duo test this simple three-factor model by regressing U.S. large cap manager performance against rolling 12-month returns of each factor, overlaying the predicted data against actual results.
