Slapping On the Cuffs

Portfolio managers have long had their stock-picking prowess judged against one benchmark or another which, during good times, turns out to simply serve as a means to quantify their performance. However, in bad times, comparison to such benchmarks turns out to be an unpleasant exercise, as institutional investors and mutual-fund trustees demand returns which, at the very least, match the relevant benchmark or index.

According to Gavin Little-Gill, senior analyst at Needham, Mass.-based TowerGroup, that demand is creating portfolio managers who find themselves limited in their ability to think creatively when stock-picking. Some investors, says Little-Gill, are requiring that their portfolio's weighting exactly match a particular benchmark or index's sector weighting, leaving little difference between their portfolio and the benchmark they are trying to beat. "People are coming down and handcuffing the portfolio manager," says Little-Gill.

Such handcuffing is being done to prevent portfolio managers from slipping out of a fund or portfolio's mandate by overloading on one sector, what Little-Gill terms "scope creep." During the late 1990s, this trend saw portfolio mangers engage in "irrational exuberance" for technology stocks.

But Little-Gill says there are more effective ways not to repeat the past, such as using the tools that buy-side institutions already have in place. These tools include traditional risk-measurement tools, such as those provided by the dominant vendor on the equity side, Barra. Simply mimicking the benchmark, contends Little-Gill, may be a self-defeating, and essentially futile, effort at reducing risk. "That limits sector risk but you still have security-specific risk, country risk and currency risk - That doesn't stop you from buying Enron as opposed to Mobil," he says.

The goal should be to create an environment where the portfolio manager has some freedom of action while the risk level stays in line with the underlying benchmark. "They should be focusing on risk reduction by focusing on the relative value-at-risk (VaR) of portfolios and using tools that let them look at the correlation coefficient of individual securities relative to benchmark securities," says Little-Gill, who explains that the correlation coefficient is the relationship between the movement of one particular security and another.

Little-Gill says the recent trend of mimicking the sector weighting benchmarks is a break with the past. "When I say to you, 'Here is my portfolio and I want you to have some discretion but performance should not veer more than 5 percent from the S&P 500,' that is one thing but instead people are saying, 'I want you to invest in the same sectors as the S&P 500.' They are essentially creating portfolio covenants that are restrictive by sector."

He says that this is a perplexing way of going about portfolio management because it leaves little room for managers to justify their fee. "Why am I going to pay 1.5 percent so a portfolio manager can invest in the same sectors as the underlying benchmark?"

Right now, he says, "Everyone is so afraid of under-performing the benchmark they don't take chances, but with such restrictions you eliminate the ability of the portfolio manger to use their brains and skills and you still don't necessarily bring about risk reduction."