June 12, 2012
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Benchmarking unconstrained, “go-anywhere” managers is difficult. Common methods to determine an appropriate benchmark – such as an ex-post regression of how the fund was invested – can obscure the actions of the manager. Is the only solution to simply select an arbitrary benchmark and proceed accordingly? Should we eschew a benchmark altogether?
I was interested to see a recent article highlighted in Advisor Perspectives, by Andrew Pyne of PIMCO, called, “Equity Investing: From Style Box to Global Unconstrained.” I was hoping PIMCO might have new solutions to the problem of benchmarking unconstrained portfolios, but alas I found that Pyne was covering well-worn territory.
For Pyne, and for PIMCO, the question is, “should managers be style-constrained within the equity universe, or should they essentially be given the flexibility to wander outside of a particular Morningstar-defined style box within the equity universe?” In concluding that managers should be given such freedom, Pyne reviews a study of “active share” by Martijn Cremers and Antti Petajisto, both of Yale University, which found that during the past several decades portfolio managers have become less “active” and more like “closet indexers.” I devoted an entire chapter to this study in my 2009 book, “Buy and Hold is Dead (AGAIN), the Case for Active Management in Dangerous Markets.” I concluded then, as now, that the study is only interesting in the context of comparing the performance of style-constrained money managers to a single index, and it has little to say about managers of portfolios that are completely unconstrained at the asset class level.
What Does It Mean To Be Unconstrained?
In PIMCO's definition of “unconstrained,” managers would be free to own LG (large growth), LV (large value), MG (mid growth), MV (mid value), SG (small growth), SV (small value), and even international equities in their pursuit of higher absolute returns. To be clear, though, PIMCO is not advocating that managers should be free to own any asset class, or particularly non-equity asset classes. Even PIMCO's “unconstrained” funds generally still must stay within their overall asset class; to do otherwise would create even more chaos than allowing so much freedom just within equities. For example, PIMCO publishes such restrictions for their Unconstrained Bond Fund. According to PIMCO, the purpose of the constraints in this case is to make certain that the fund retains the characteristics of a bond fund, while giving the manager flexibility to own any kind of fixed-income security that might add to returns.
Clearly, PIMCO hasn’t decided to put itself out of business by creating a fund that doesn’t at least fit into a fixed-income style. After all, how would investors know what to do with such a fund? If it isn’t a fixed-income fund, then what is it, and how would you use it in the context of a diversified portfolio? Fortunately, the mere fact that the fund is still a “fixed-income fund” allows for some way to benchmark PIMCO managers to determine if they are earning positive alpha.
But when the portfolio is truly unconstrained and has no clear benchmark, how do you do the math? I know of what I speak when asking this question, because our portfolio construction at Pinnacle Advisory Group is not constrained at any level, including at the level of asset classes. Instead, we are constrained by volatility, not asset class targets, to allow our analysts freedom to select from any asset class that they believe offers good value (and to avoid any asset class that does not). A similar approach drew attention in the recent "Same Returns, Less Risk" Wall Street Journal article.
While such flexibility is very helpful for allowing our analysts to do what they do best, in the process we have created a relatively new kind of investment animal that makes life difficult for everyone who wants to analyze our investment returns, regardless of whether they are a retail investor or an investment professional. That was the challenge we set out to overcome.
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