Counterpoint

Robert Arnott

eter Martins summary of the case against relative performance measurement and geographical asset allocation is a clear statement of the key issues. However, the common view that relative performance does not matter, except as it relates to competitive positioning of investment managers and consultants, misses a few truly crucial realities. One relates to the very basic question, What is wealth? The second relates to the dangers of maverick risk.
WHAT IS WEALTH?

Unless a fund is planning to spend its assets very soon, wealth is not measured by the market value of its portfolio. Wealth is measured by the ability of that portfolio to serve the funds future obligations. With pension obligations that stretch over decades, as with endowment and foundation obligations that are intended to serve more-or-less perpetual commitments, the immediate liquidation value of the portfolio is startlingly unimportant. What matters is the real return that the portfolio will deliver over the long term. To see why this is so, lets consider which of the following is more valuable: a 10% gain that stems from market appreciation, or a 10% gain that stems from a managers risk-adjusted outperformance (its alpha) relative to a flat market? Most people, including many professional investors, would answer that the two gains are identical, that there is no difference between them. In fact, there is an immense difference.

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Rob Arnott If a market rally pushes up a bonds value by 10%, that does nothing to change the prospective dividend and principal payments to the bonds holders. The long-term investor is not wealthier by so much as a penny, if those coupon and principal payments match the obligations that the portfolio is intended to serve. Similarly, if an equity market rises in value by 10%, expected long-term future dividends and earnings in the portfolio are little changed. Market appreciation and depreciation are surprisingly uncorrelated with the increases or decreases in the underlying fundamental dynamics of the market, a fact explored at great length by Bob Schiller from Yale in two articles in American Economic Review (1981, v71(3), 421-436, and 1990, v80(2), 58-62). On the other hand, a 10% gain from performance that exceeds market returns improves the long-term earning power of the portfolio by the full 10%. It is as though the fund is starting out 10% richer. Gains from managers alphas are worth 100 cents on the dollar. Gains from market appreciation (or losses from market depreciation) are worth mere pennies on the dollar to all investors except those who intend to spend the money soon. This often-overlooked reality also shows up in the raw data associated with major bull and bear markets. Over the course of the 1991-1998 bull market in the U.S., a 60/40 portfolio (60% in U.S. equities, 40% in longterm government bonds) would have returned 17.1% per year. But the income generated by that portfolio would have grown by only 8.2% per year. That was the amount of additional cash available to the fund for spending, with no reliance on Market appreciation and depreciation are surprisingly future market appreciation. The annual growth in true wealth duruncorrelated with the ing the immense bull market of increases or decreases in the the 1990s was a mere eight cents on the dollar. underlying fundamental What about losses in the greatdynamics of the market. est market crash of the past 200 years? From mid-1929 to mid1932, U.S. stocks fell 82%. That is like losing half of your assets in a single year, losing half of whats left in the next year, and losing half of the slender remainder in the third year. A breathtaking collapse of market values! The 60/40 investor would have seen portfolio values drop during this cataclysm by 59.3%, or 25.9% per year.

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Invest In New Habits Counterpoint During the same period, however, the real income generated by For investors who wanted to the 60/40 portfolio would have spend more than their fallen a mere 6.6%, or 2.3% per income immediately, most of year. A fund spending only its their wealth evaporated in income would still have had $93.40 to spend for every $100 it the market crash of 1929had before the crash. This is 1932. For investors with a painful, to be sure, but it is a very longer horizon, seeking to modest decline relative to the collapse of asset values. For investors serve long-term obligations, who wanted to spend more than remarkably little of their true their income immediately, most of wealth was lost. their wealth evaporated. For investors with a longer horizon, seeking to serve long-term obligations, remarkably little of their true wealth was lost.
WHY IS THE FOCUS ON RELATIVE PERFORMANCE SENSIBLE?

The focus on returns relative to the market and to other funds stems only partly from so-called agency effects, in which investment managers are looking out for their own self-interest, rather than focusing on the true wealth of their clients. The more powerful reason is the fact that true wealth is correctly defined by relative performance, and is surprisingly unaffected by bull and bear markets. If bull and bear markets dont matter, what does matter? Alpha and relative performance matter. The pursuit of alpha is a very valuable quest; the avoidance of negative alpha is equally valuable. There is a second reason why relative performance matters a great deal. Companies, universities, and other organizations do not exist in a vacuum. If my companys pension fund produces a 15% annual return over the course of a decade, I might be well pleased with the substantial increase in the assets of the pension fund. But suppose my competitors earned a 20% annual return on their pension assets. What has really happened? My competitors find themselves with a lower cost of funding pension obligations. That means they will be in a stronger position than my company to improve benefits for employees or reduce pension costs. They will therefore be able to improve profit margins, reduce product

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Rob Arnott costs, or invest in new products. My companys competitive position has faltered. The same holds true for universities seeking to improve their programs or facilities vis--vis other universities, or for counties or states seeking to lower their tax rates or improve services vis--vis other locales, to attract new industries or companies. Make no mistake about it, the reason relative performance is a central focus of the investment management business is that relative performance matters!
ON GEOGRAPHIC ASSET ALLOCATION.

No benchmark comes with a guarantee of positive returns, especially in the short term. (Of course this is also true of absolute return benchmarks.) When investors consider an allocation to an asset class, they want to find a benchmark that captures the asset class as thoroughly as possible. For global investors, existing financial markets, which happen to be national markets, are the entry points to building a portfolio. They are markets that are both measurable and available to global investors. The logical benchmark, therefore, continues to be the opportunity set represented by those markets. While there have been problems with national and multi-national market benchmarks as there often are with benchmarks viewed historically there is no evidence yet that any global selection of securities will prove to be a better global benchmark going forward. If such evidence develops over time, Im sure well hear about it.

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