Don’t settle for the index hugger

The professional search for investment talent is being conducted in the same way that the drunk looks for his keys under the light of a lamppost. When asked where the keys were lost, the drunk replies: “Up the street, but the light is much better here.”

When it comes to investment fund selection and allocation, financial advisers are doing what is easy rather than what makes sense. They ought to customize the benchmark rather than limit their comparisons to off-the-shelf indexes such as those from Russell Investments of Tacoma, Wash., and Standard & Poor’s of New York, and they should allocate to talent rather than to style boxes.

In other words, consultants should fish for talent with fly rods, not flypaper.

More thoughtful, albeit more difficult, angling for active managers will enrich investment talent harvests and their applications.

Fund selection criteria favor index funds and index huggers because style boxes undermine the search for skill. Equity allocations are preordained to set style boxes, each with their own index, and managers are sought to track these indexes.

Risk is defined at the individual-manager level as tracking error.

Today’s approach begins with a decomposition of the stock market into style segments — for example, 35% large growth, 35% large value, 15% small growth and 15% small value. Managers are chosen for each of these four assignments, and assets are allocated to the winners at the market weights.

This simplifies the process but compromises the talent search.

Because risk is defined as tracking error, index huggers have an edge in manager searches. But recognize that alpha and R-squared are from different alphabets: Low tracking error limits the alpha that can be achieved.

Populating our asset allocations with index huggers makes for a mediocre but safe portfolio. So the problem with this approach is that it is hard to make a good cioppino when all the ingredients are bland.

Our industry has drunk the index huggers’ Kool-Aid and has reversed a process that was in place for some time.

Not too long ago, we sought skill wherever we could find it. Then, once a talent pool was filled, allocations across this pool were optimized for diversification.

Risk was defined in the aggregate as failure to achieve objectives, and it was talent that mattered.

Risk management specialist Frank Sortino, director of the Pension Research Institute in Menlo Park, Calif., continues this tradition with his latest work.

OMEGA EXCESS

He develops his talent pool using a measure he calls Omega Excess, which customizes the benchmark to each manager’s style profile. Mr. Sortino then allocates to this pool to maximize total portfolio Omega Excess while minimizing style bets.

Each manager comes into the solution as a blend of styles.

If some non-index managers have skill, this framework built for index huggers won’t find them. Limiting our analyses to off-the-shelf indexes will routinely have us make bad judgments regarding liberated non-index-huggers, declaring losers to be winners and successes to be failures.

Treating everyone as if they were an index hugger is an evaluation mistake. We need to bring the best custom benchmark to each liberated manager rather than force these square pegs into round holes.

Otherwise, we will miss a lot of talent. Some investment firms are at their best when left unfettered from indexes.

This doesn’t take these firms off the benchmark hook; it customizes the hook.

Some say that there is no benchmark for a particular manager, especially hedge fund managers. This is usually an indication that they don’t understand what this manager does.

We shouldn’t invest in what we don’t understand.

Trolling for talent isn’t as easy as some think, unless the only catch you are after is index huggers. Indexed nets fill with porpoises.

No offense to index huggers — some of my best friends love their indexes, and I am glad they have an edge.

In the 1980s, there was significant interest in custom benchmarks, and a few firms sprang up to provide what were then called “normal portfolios,” which are custom collections of stocks with custom weights. The Charlottesville, Va.-based CFA Institute’s Benchmark Committee Report recommended the use of custom benchmarks over indexes and peer groups.

The good news is that today, we have a variety of tools, such as style and factor analyses, that make it straightforward to construct custom benchmarks.

Among other benefits, these tools give us a sense of how a manager differs from an off-the-shelf index to illustrate sources of performance differences. The tools are there waiting for the thoughtful user.

Once the right benchmark is created, there are additional tools that can help us accurately evaluate investment performance.

My firm offers one such tool, Portfolio Opportunity Distributions.

Other tools, such as Mr. Sortino’s Omega Excess, can be used effectively to achieve this goal. The ultimate beneficiaries of these improved tools are our clients.

You would think that investment managers would also benefit, but obfuscation is good in the very competitive investment game. Skilled sales and client relationship people thrive on benchmark subterfuge, presenting indexes and peer groups that make them look best.

Ronald J. Surz is president of PPCA Inc., an investment technology firm in San Clemente, Calif., that specializes in performance evaluation and attribution software, primarily for financial consultants and sophisticated institutional investors.