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Track if your fund manager is taking the best shot

Graham Hand  |  07 Apr 2022Text size  Decrease  Increase  |  
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After an extraordinary career guiding Amazon to the peak of global retailing, former CEO Jeff Bezos delivered a final message in 2021 that was “of utmost importance I feel compelled to teach”. He wanted all his staff and shareholders to “take it to heart”.

It contains relevance for fund managers about distinctiveness and keeping alive the skills and risk appetite that make them special. Both retail and professional investors should also take it to heart when talking to the people who look after their money.

Focus more on tracking error

Most asset managers conduct public-access webinars or events, including Q&A sessions, while a more privileged, one-on-one contact is granted to professional analysts. It’s a time to learn how fund managers construct their portfolios.

While every meeting, public or private, features fund performance and macro trends, analysts delve more into specific measurement metrics. Some of the numbers, such as the Sharpe Ratio or Information Ratio (and heaven help us, kurtosis and skewness) may seem a little arcane, but tracking error is easy to understand, yet it is rarely discussed in retail presentations.

It’s a useful concept which deserves a regular check. Put simply, tracking error shows how closely an active portfolio follows its benchmark index. It measures the active risk due to decisions made by the portfolio manager. It should not be called an 'error', as it should be the result of a conscious action.

For a cap-weighted index fund, such as an Exchange Traded Fund (ETF) designed to follow a standard index, the tracking error should be as low as possible. A competent index provider should have processes which ensure index replication wherever possible. For example, the five-year tracking error for the Vanguard Australia Share Index Fund is a low 0.43% but it is 4.32% for the Vanguard Australia Shares High Yield Fund. The latter is not trying to track the broad index.

For active managers, a low tracking error should be the kiss of death. They should be having a crack - or if you prefer, swinging the bat or giving it their best shot - weighting and selecting stocks away from the index. Nobody should pay high active fees for a low tracking error fund.

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For an active fund, what’s the right number?

Jeff Bezos’s final letter to Amazon shareholders

Let’s digress before returning to that question.

Jeff Bezos's business acumen changed the face of retailing around the world and created a company by the end of 2020 with 1.3 million employees, 200 million Prime members, 2 million small and medium-sized businesses selling in their store and wealth creation of almost US$2 trillion. He wrote his first letter to shareholders in 1997, and his final in 2021 when he left as CEO.

Here is a long quote from Bezos’s final letter:

“This is my last annual shareholder letter as the CEO of Amazon, and I have one last thing of utmost importance I feel compelled to teach. I hope all Amazonians take it to heart.

Here is a passage from Richard Dawkins' (extraordinary) book The Blind Watchmaker. It's about a basic fact of biology.

"Staving off death is a thing that you have to work at. Left to itself – and that is what it is when it dies – the body tends to revert to a state of equilibrium with its environment. If you measure some quantity such as the temperature, the acidity, the water content or the electrical potential in a living body, you will typically find that it is markedly different from the corresponding measure in the surroundings. Our bodies, for instance, are usually hotter than our surroundings, and in cold climates they have to work hard to maintain the differential. When we die the work stops, the temperature differential starts to disappear, and we end up the same temperature as our surroundings. Not all animals work so hard to avoid coming into equilibrium with their surrounding temperature, but all animals do some comparable work. For instance, in a dry country, animals and plants work to maintain the fluid content of their cells, work against a natural tendency for water to flow from them into the dry outside world. If they fail they die. More generally, if living things didn't work actively to prevent it, they would eventually merge into their surroundings, and cease to exist as autonomous beings. That is what happens when they die." ...

We all know that distinctiveness – originality – is valuable. We are all taught to "be yourself." What I'm really asking you to do is to embrace and be realistic about how much energy it takes to maintain that distinctiveness. The world wants you to be typical – in a thousand ways, it pulls at you. Don't let it happen.

You have to pay a price for your distinctiveness, and it's worth it. The fairy tale version of "be yourself" is that all the pain stops as soon as you allow your distinctiveness to shine. That version is misleading. Being yourself is worth it, but don't expect it to be easy or free. You'll have to put energy into it continuously." (my bolding)

It’s the same for active fund managers

Investors should apply the same principles to their active fund managers. Any with low tracking errors of 1% or 2% are replicating their surroundings, and to use the Dawkins analysis, their funds deserve to die. That is not what they are paid to do. They should take a view that differs from the market, or they should pack up and save their clients the active fees.

The problem is often acute in large funds where, having spent years building a business and collecting loyal clients, the temptation is to remove the business risk of underperformance. Some large funds have small tracking errors, where the fund managers have decided there is career risk in losing money and index returns are sufficient. Management has decided, to use Bezos’s words, “to bring us into equilibrium with our environment.”

Funds industry veteran, Chris Cuffe, wrote in this article:

“It’s astounding in Australia the number of managers who won’t risk being too different from the index. If they underperform for a short period due to departure from the index, they worry they will lose funds (and maybe their job will go as well).

I listened to an active Australian equity manager tell me how proud he was of being index-unaware, yet his exposure to financials was 27%, not the 30% per the index. This is not an active position at all and he is surely being driven by the index. I would think that a position of half or double or nil is more like an active view.

The best investors I deal with are totally benchmark unaware, even as to what markets they invest into, local or overseas or cash or whatever.

The lack of willingness to be different from a benchmark has a lot to answer for in encouraging mediocre investing across the world. The dominance of these behaviours is far greater than anyone will admit. It drives many professionals to bizarre investing.”

What is a reasonable tracking error for an active fund?

Tracking error is a measure of how actively a fund is managed. It is calculated as the standard deviation of the difference between the returns of the portfolio and the returns of the benchmark.

The index might be considered the neutral starting point for portfolio construction, and the tracking error informs the investor what to expect in variations from the benchmark. It’s also an explanation of a fund’s volatility not caused by market beta.

An active manager should accept a tracking error of at least 5% and 10% is considered normal. According to Fidelity, the tracking error of the median fund using the US S&P500 as a benchmark is 9.1%. A number such as 20% or 30% is expected from a manager taking strong bets in a concentrated portfolio.

Jose Garcia Zarate, Associate Director of Passive Strategies at Morningstar, writes:

“A useful analogy to understand these concepts is that of a race between two cars, where one car is the index and the other is the fund. Tracking Error tells you how close the two cars were to each other during the race.”

He gives the following example to calculate the tracking error:

  • Tracking Error = Standard Deviation of (P–B)
  • P = the return of the investment
  • B = the return of the benchmark

Assume there is a fund benchmarked to the ASX200 index with fund and index returns as follows over a five-year period:

(Click to enlarge)

The standard deviation of this series of differences, the tracking error, is 2.8%. If the sequence of return differences is normally distributed, it can be expected that the fund will return within 2.8%, plus or minus, of its benchmark approximately every two years out of three. This manager is a benchmark hugger.

Investors should also expect a fund with less volatile investments, such as bonds and loans rather than equities, to have a lower tracking error.

Here is a sample of active equity fund tracking errors. Measuring over time may show whether the manager is changing active bets.

As investors should hope and expect, some of the smaller boutiques such as Montaka, Tribeca Resources, Ophir, Forager and Cadence are having a good go. Their clients should appreciate that there will be significant divergence from the benchmark, as they are high conviction managers. The long-established LICs such as AFIC and Argo are closer to their benchmarks, but also cheaper and safe and reliable options. The big active managers tend to sit somewhere between, but names such as Fidelity and Australian Ethical are taking decent bets.

In summary, individuals select active fund managers to outperform, and that is only possible if positions are taken away from the index. A tracking error of 1% cannot achieve much, and it’s not worth paying active fees.

But don't complain if a boutique fund manager with a high tracking error delivers a bad year. It is an inevitable part of diverging from safety.

Next time you are at a presentation, ask about the fund’s index and the tracking error. If it’s not at least 5%, ask why the manager is not having a decent go. If it’s over 15%, expect wide variations but at least you know what you’re paying for.

Final words from Bezos

If Jeff Bezos had gone into funds management, you can be sure there would be high tracking errors and no index hugging, but he goes much broader than that. He implores all of us to be distinctive.

“I would argue that it's relevant to all companies and all institutions and to each of our individual lives too. In what ways does the world pull at you in an attempt to make you normal? How much work does it take to maintain your distinctiveness? To keep alive the thing or things that make you special?”

 

Graham Hand is Editor-at-Large for Firstlinks. This article is general information and does not consider the circumstances of any investor.

is the editorial director of Morningstar Australia.

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