GMO’s Jeremy Grantham recently asked: What would you do if you had to manage Josef Stalin’s pension portfolio?
Stalin says you must earn the rate of inflation plus 4.5% on his pension assets over the next decade. Success means you get a nice dacha on the Black Sea and a pension of your own. Failure means you get shot.
Ben Inker, Grantham’s colleague at the asset manager Grantham Mayo Van Otterloo, discusses this challenge in the group’s February letter to investors.
“It is an entertaining problem setup, and for the more quantitative among us, leads to a refreshingly simple utility function — maximize the probability of meeting or beating the target return,” wrote Inker, the head of GMO’s Asset Allocation Team. “But if Stalin actually had any intention of living off of his pension, it is a lousy ultimatum to give his chief investment officer.”
Stalin’s mandate, he explains, “completely ignores the impact of magnitudes, and magnitudes matter. Barely missing the goal and achieving 4.4% above inflation is importantly different than returning 15% below inflation, and for Stalin, they are the same — failure. But Stalin may be on to something … just not quite the way he originally intended.”
Inker says Stalin sure has a “high-risk” style of investing.
To make him happy, you’d have to find investment managers that run portfolios “as if they were solving that [mandate]. They are the concentrated, high tracking error, ‘high conviction’ managers that have gained a significant following, particularly in the endowment and foundation universe,” he explains.
Who should hire such managers? Only those who think they are good at identifying talented active managers, the asset manager says.
“But just as important and somewhat less intuitively,” coming through for Stalin’s mandate “also requires … [money managers who] are significantly better than the average CIO at avoiding the performance chasing that traditionally accompanies the firing and hiring of managers,” Inker said.
Meeting these two requirements means you might be able to build a portfolio than gives you higher returns without much downside tied to greater volatility or tracking error.
“If you can’t meet both requirements, such aggressive managers are more likely to hurt you than help,” the GMO asset manager said.
In his letter, Inker also looks at Grantham’s analysis in a different way which is, he says, “a little simpler.”
Instead of gauging total return, he zooms in on relative return terms versus an ownable benchmark and maximizing the likelihood of outperforming a benchmark by 3% or more, because the portfolio that maximizes that probability should have an expected alpha much higher than 3%.
Why is that?
“If you run a portfolio targeting an expected alpha of 3%, you should have a roughly 50% chance of achieving 3% or higher alpha. If you run a portfolio targeting an expected alpha of 7%, your chance of achieving or exceeding 3% alpha is almost certainly higher than 50% — you could underperform your alpha target by up to 4% and still achieve 3% alpha,” he explained.
Keep in mind, Inker adds, that the probability of achieving at least a target return is a function of both the expected alpha and volatility, with higher alpha being good and higher volatility being bad.
A portfolio with a “normal” target of achieving 3% alpha has the lowest tracking error, 4.4%, and an information ratio (IR) of 0.68. The Stalin version — which aims to maximize the chance of getting at least 3% alpha, has an expected alpha of 6.9%, a tracking error of 13% and an IR of 0.53.
Why not manage an entire portfolio like Stalin?
A 13% tracking error is “an awful lot!” Inger explains.
Plus, the Stalin portfolio has a 10.6% chance of underperforming by 10% or more; the traditional portfolio has just a 0.1% chance of doing so.
“Show me the CIO of an institution who wants to be in a position to have to explain underperforming its benchmark by 10% more than once a decade, and I’ll show you a CIO who is counting on being in the job less than 10 years,” said Inker.
A Piece of the Portfolio
If you don’t want to Stalinize your whole portfolio, there are ways to use a Stalinesque piece (or pieces) in it.
To outperform a benchmark by at least 1%, you’ll need to hire 20 outside managers focused on beating their respective benchmarks.
With trading costs and management fees for the portfolios totaling 1%, how can you produce 1% excess returns?
You could tell your managers to shoot for 3% alpha, says Inker: “The 50% of your managers with skill will average 3% alpha. The 50% with no skill will average -1% due to costs, and therefore your portfolio will achieve 1% alpha on average.”
In this scenario, your tracking error should be 1% and IR 1.0.
If you tell your managers to act as if you are Stalin (and maximize the chance of getting 3% alpha), the resulting portfolios should be much less efficient than the 3% expected alpha portfolios, and the IR could be from about 0.68 to around 0.53.
Plus, the costs of the strategy could be 1.5% in total.
“If you really expect your managers to swing for the fences, they are generally going to demand upside to make up for their greater odds of getting fired for a run of bad luck,” the asset manager said.
After looking at the different scenarios and considering the costs, he concludes: “For any hit rate where it makes sense to hire active managers in the first place, Stalin seems to dominate the non-Stalin strategy. Yes, you’ve got higher tracking error, but the alpha is much higher.”
Does this mean you should “go Stalin or go home?”
Pretty much, Inker explained: “If you believe you have a hit rate hiring talented active managers above 20%, hire Stalin managers. If you believe your hit rate is lower than 20%, index your portfolio.”
Not So Fast
Still, the behavioral requirements for this approach are “a lot tougher” than you might think, he says.
For instance, if you assume the Stalin managers have a lower IR than other active managers, then making hiring and firing decisions based mainly on performance can be expected to produce bad results.
Just like investing in general, “It is not enough to find talented managers. It is also critically important to time your hiring and firing of managers well,” Inker explained.
He concludes that seems like “a bad idea” to manage a full portfolio like Stalin, since it causes you to be “extremely aggressive.”
Hiring some Stalinesque managers could diversify returns.
But that required you believe, first, you have very strong hiring skills and, second, you avoid performance chasing in these hiring and firing moves. This is because performance chasing carries the risk of investing in expensive talent and losing.
Furthermore, the scale of this loss increases with the managers’ aggressiveness. Thus, such portfolios must be treated “with particular care,” Inker says.
While recognizing that some endowments and institutions (think Yale) have done well with an aggressive approach and other factors, the GMO asset allocator points out that you have to get lots more right to win with the Stalinesque approach.
This means having a very strong talent with hiring, not chasing performance when hiring and firing, and having lots of good luck, Inker says.
GMO has avoided Stalinesque portfolios, he explains, because of the fear that clients will lose out due to poor timing in entering and leaving outperforming portfolios.
And that means aggressive portfolios carry “a greater risk” than those with more moderate tracking error. In addition, few clients can hire and fire managers without generating lots of “bad luck” in the process.
Still, Inker concludes, “We would be happy to talk to … clients about what a GMO ‘Stalin portfolio’ would look like and whether it might fit into their overall investment strategy.”
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