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?