There is only one way to see things – until someone shows you how to look at them with different eyes.   Pablo Picasso

The professional search for investment talent is currently 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, advisors are doing what is easy rather than what makes sense. They ought to be customizing the benchmark rather than limiting their comparisons to off-the-shelf indexes, like Russell and S&P, 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.  

Skill First

Fund selection criteria currently favor index funds and index huggers, because style boxes undermine the search for skill.  Equity allocations are pre-ordained 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 current approach is that it’s hard to make a good cioppino when all the ingredients are bland, even if they are safe.  Our industry has drunk the index huggers’ cool aid, and has reversed a process that had been 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. Dr. Frank Sortino continues this tradition with his latest work. Dr. Sortino develops his talent pool using a measure he calls “Omega Excess” which customizes the benchmark to each manager’s style profile. He then allocates to this pool to maximize total portfolio Omega Excess while simultaneously minimizing style bets. Each manager comes into the solution as a blend of styles.

Square Pegs

If (and this is a big If) some non-index managers have skill, this framework built for index huggers will not find them. Limiting our analyses to standard off-the-shelf indexes will routinely 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 simply at their best when left unfettered from indexes. This doesn’t take these firms off the benchmark hook; it customizes the hook.

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