I had illustrated in the past why managers closet index. That`s because even a single misstep in an individual position could sink portfolio performance (see How Valeant revealed the dirty little secret of fund management). In this post, I would like to focus on how style and factor exposures affect business risk.
I recently came upon a study by Research Associates, which showed the tradeoffs between investment returns and business risk. The authors modeled a series of hypothetical portfolios with different styles, namely value, growth, momentum, quality, and random selection, which they called the "4 Orlandos", for the period 1967-2016. As it turns out, the styles that showed the best performance also had the highest chance of getting a manager fired.
The termination criteria for a manager (which they called an "agent") is detailed below and roughly reflects the patience level of institutional sponsors:
We select two highly stylized rules for a hypothetical investment board to use in evaluating the agent’s performance:
1) Fire the agent if more than 50% of funds selected by the agent underperform the benchmark in a given period.In the light of these results, the big question for institutional investors is, "We all want good performance, but how far do you want to stick your neck out?"
2) Fire the agent if the equally weighted portfolio aggregated from the selected funds underperforms the benchmark by more than 1%.
The full post can be found at our new site here.