2010: A Truth Odyssey
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The world is in constant need of a refresher course on the obvious.
James Picerno, Author.
As I rang in 2011, I found myself in awe of how quickly time had passed and how much things have changed. The 1968 movie “2001: A Space Odyssey” caught our fantasy as a journey into the distant future, yet here we are a decade beyond 2001 (and more than 40 years after the movie came out). And who ever thought Dick Tracy’s two-way audio-visual watch could ever exist outside a comic strip, or that 3-D color TV’s would hang on walls like paintings? Transporters and holodecks1 can’t be far behind.
The investment profession has also been on an odyssey: a quest for truth, spurred by the recent financial crisis. The truth was easier to grasp before investing became so complicated and challenging, due to the unique combination of quantitative easing, bank failures, the mortgage crisis, and other events. The recent lessons we’ve learned about excesses and fraud, especially those of 2008, have not yet been entirely digested, yet they should certainly not be forgotten.
So in this end-of-year commentary, I review some of those lessons with an eye to the truth so we can benefit from them in the future. But before I bring us back to that painful 2008 and what has happened since, let’s review the year 2010. I then discuss 2008’s lessons, and conclude with my traditional review of the longer-term history of U.S. markets over the past 85 years, the longer odyssey.
The year 2010 in review
I’ve been writing these commentaries for 10 years, and this year I’ve decided to do something entirely different that will lead into the discussion of the odyssey of investment truths. I’ll review the year by analyzing why popular indexes, namely the S&P500 and the EAFE, performed as they did. I provide attribution analyses set against a backdrop of the entire market. Prepare for a “deep dive.”
The US stock market
We begin with an analysis of the style composition and performance of the S&P500, as shown in the next exhibit.
The portfolio in the exhibit is the S&P500 index and the benchmark is the entire U.S. stock market, as provided by Compustat. Let’s begin with a discussion of the style make-up of the S&P as shown in the bottom of the graph. Unsurprisingly, the S&P has a large-company orientation, especially tilted toward large-value companies. The total market is about 30% large-cap value, whereas the S&P is 40% large-cap value.
Throughout this commentary I use Surz Style Pure® indexes, defined at Style Definitions.
This large-company orientation hurt the S&P because smaller companies performed better in the year, as shown by the middles of the floating bars in the center graph. These floating bars represent pure scientific peer groups described at Portfolio Opportunity Distributions (PODs). The median of each POD is the return for that style in aggregate and the ranges are the return opportunities for that style. As you can see, smaller companies returned in excess of 25%, with small-cap growth leading the way with a 33% return, while larger companies lagged with returns in the low teens. Large-cap value in particular returned 14%. It was primarily this concentration in large-value companies that caused the S&P (15%) to lag the total market (18%) in 2010, as shown in the far right table and floating bar. In other words, allocation to styles penalized the S&P relative to the total market in 2010.
The other component of attribution is stock selection, which we can see in the location of the dots in the exhibit. For the most part, the stocks selected by the S&P committee performed near their respective medians within each style, with the exception of smaller companies, which didn’t matter much because the allocations were minimal.
You can use this exhibit to rank individual managers within styles, as well as rank their style components. Just plot your dots in the graph above. For example, locate your manager’s style in the exhibit (large value, small growth, etc.), and place his rate-of-return within the corresponding floating bar, using the scale on the left and the median from the table above as your guide. Voila, an accurate ranking.
Next, I performed a similar analysis, decomposing the S&P by economic sector, and concluded that stock selection hurt performance. But how can that be in light of what I just concluded in the previous paragraph where stock selection was not a factor? Sector allocations of the S&P are in line with those of the total market, mainly because the S&P is a large part of the total market. What we’re seeing in the next exhibit are the style impacts on performance within economic sectors: style effects manifest themselves as stock selection when the S&P is decomposed by sector.
The lesson to be learned here in our odyssey is that we need to be careful to evaluate skill rather than style. An attribution against the S&P500 by sector can be easy in some sectors and difficult in others if the S&P is not the correct benchmark. For example, a manager with a broadly diversified portfolio will have a return on Materials that is close to the 34.97% shown for the total market in the table below. This is 13% greater than the S&P’s 22.28% return in Materials, which would appear to be a big success, and it would be a big success if the S&P were the correct benchmark, but in this hypothetical we’ve said that the manager is more broadly diversified than the S&P, so the outperformance is most likely caused by style (i.e., being broadly diversified) rather than good stock picking.
The performance attribution puzzle is complicated, but well worth the time and effort to get it right. Because it tells us why performance is good or bad, attribution is a window into the future. We want confidence in the manager’s strengths, and comfort that failures are being addressed and corrected.
1. In the Star Trek TV and movie series, the holodeck was a recreational deck on board the starship Enterprise where the crew could enjoy interactive fantasies/plots with holographic sets and characters. It was a virtual reality playground.