Noise and Signal in Active Management

Executive summary:

  • To create an effective portfolio of active managers, investors should have a clear idea of which risks they can profit from and which they need to control and limit.
  • Among global equity managers the commonly held US underweight, a good example of a low conviction risk position, has contributed to broad underperformance.
  • Because so many managers hold this underweight, managing this risk through strategy diversification is challenging. Overlays are an efficient way to control this exposure.

Introduction: Intentional risk-taking and portfolio management

We are accustomed to thinking of active manager returns as being purely the result of manager skill (or lack of skill) in making dynamic investment decisions relative to a passive index.  As someone who has been researching active managers for decades, I can say that this is only partly true.  Investment managers may argue that their portfolio is ALL high conviction positions based on quality decision-making, but the reality is that even the most skillfully managed active strategies have a mix of high conviction and lower conviction positions. A multi-manager investor needs to know the difference between the two and emphasize the high conviction risks. The good news is that when managing risks through manager weights is challenging or even impossible, investors can access other tools to address outsized, low conviction risks at the total portfolio level (more on that below).

The best investment managers are specialists who have an edge in detecting future winners or losers. but who correspondingly look to limit losses when their approach is out of favor.  To successfully select and combine investment managers, one needs to not only identify their skill and how it is expressed in a portfolio (“productive risk-taking”) but also to distinguish it from all of the other positions and risks that may create tracking error but are not based on the investor’s true edge (” unproductive risk-taking). 

A good example of unproductive risk-taking is style bias—few asset owners believe that the valuation bias found in value manager portfolios or the growth bias in growth manager portfolios represents unique insight that should be reflected across one’s broader portfolio. Most investors hire managers in both styles to essentially cancel out or balance those low conviction, high risk positions.  Most investors understand that you hire an excellent value manager because they are the best value investing specialist who can distinguish the best bargains from companies that are “cheap for a reason”. The same goes for growth managers.

Investors building portfolios from multiple strategies must ensure that they focus their total portfolio’s risk as much as possible on the signal that comes from their manager’s superior investment insights and minimize risk from biases.  A particularly vexing challenge for those managing multi-manager global portfolios, and the focus of this blog, is the stretch of poor performance driven by a particularly low conviction risky position in their managers’ portfolios.

Global equity active managers are in a slump, but the reason may be simple and mostly noise.

The average performance of active global equity managers over the past several years has been poor. Many investors in Global strategies have been frustrated by the continued poor performance of the average manager. The chart below shows how over the past several years, on a three-year rolling basis, the median manager, shown by the thick grey line, has seen their annualized excess returns slip below their benchmark (Chart 1). While we do not expect the average manager to always outperform the benchmark—only the stronger managers should be expected to do so consistently—this is a concern for the category as a whole. Why have global equity benchmarks become so much harder to outperform?


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Global Equity Manager Universe Performance

In this case the source of “noise” is one of the more notable active management mis-steps of this century.  Global Equity managers have shown a persistent preference to be significantly underweight the US relative to benchmark for as long as we have tracked them (Chart 2). Below you can see the median and 25-75% quartile range of US positions in our Global equity manager universe. For nearly 10 years the range has been below 0 and the median level has fallen from -5% to over -10%! The reasons given by managers we research range from “the US is too expensive” to predictions of impending recession to a desire to diversify away from what has become as high as a 70% weight of US stocks in Global Equity Benchmarks.


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Global Equity Manager BM-Relative Weights In US Equity

This has occurred during an extended 10 year+ period of US equity outperformance over the global benchmark (Chart 3)—from well before the recent period of tech stock dominance and including the impact of a powerful US dollar rally. However logical one might think a US equity underweight may be, it has been a consistent loser for the universe, one we would characterize as static rather than active management. In our own multi-manager portfolio, we try to limit the level of risk from country positions for this reason through the use of targeted overlays. Looking at the universe it appears to be a clear bias that is only getting bigger.


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MSCI World Index Returns vs Russell 100 Return

It is not a coincidence that performance of the average global equity manager has suffered while US equity has dominated global equities. Our rough estimate of the impact of US equity underweights on average Global equity manager performance is shown below (Chart 4) and accounts for a large portion of the underperformance of the universe.


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Median Global Equity Portfolio



In global portfolios, the common US equity underweight position should be treated as an unproductive risk and efforts should be made to manage that risk so it is not a large proportion of total tracking error.  In our own portfolios we do so as we believe excellent global equity managers offer superior and more diversifiable sources of return in the form of security selection. I write this knowing that at some point US equity will underperform world equity and this position will pay off.  There is little evidence, though, that active global equity managers have strong insights on when this will happen.


Given nearly every manager is significantly underweight, there is a limit to the risk reduction that can be achieved with manager weight adjustments. We recommend the use of futures overlays to ensure that the US position does not dominate portfolio risk budgets while other high conviction position can be maintained. The good news is that this is quite straightforward to do—if a total portfolio is 7% underweight the US, one could buy 7% of S&P 500 futures and sell 7% of futures across other European and Asian futures contracts to essentially erase that position without losing the value of underlying stock positions.  Investors may choose not to fully neutralize the risk as they wish, but rather reduce its magnitude so that it is a modest driver of total tracking error.