Facing Reality by Questioning Some Common Beliefs

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There are many sides to reality. Choose the one that's best for you.
Eugene Ionesco, Rhinoceros

I’ve decided to do something different in this quarterly commentary. I begin as usual with a review of first quarter market performance.  Then I turn my attention to some commonly held beliefs that I regard as mistaken, as shown in the figure below. 

Mistaken Belief


(1) Growth stocks have dominated in the
      last 5 years.

Style providers have misclassified fallen financials, distorting style index returns. 

(2) Active managers as a group always
     underperform their passive indexes.

This phenomenon is exacerbated by a procedural bias rather than ineptitude.

(3) Market indexes, like the S&P500 and
      the Russell 3000, make the best
     “Core” portfolios.

The very definition of “Core” is violated by a market index. Even more importantly, a true core index does a lot of good.

(4) “Active share” predicts alpha.

Active share is a measure of conviction, which may or may not add value.

(5) Target date funds defend against
      losses as the target date nears.

2008 proved that this is not true, and little has changed since.


First quarter 2012 investment markets

Domestically, growth stocks were in favor, led by technology and financial companies. Outside the US, smaller value companies led the way.  I’ll review the year by analyzing why popular indexes, namely the S&P500 and the EAFE, performed as they did. I provide StokTrib attribution analyses set against a backdrop of the entire market.

US stock market

We begin with an analysis of the style composition and performance of the S&P 500, as shown in the next exhibit. The total market returned 12.79%, about the same as the S&P’s 12.59%.

Portfolio vs Peer Group

The floating bars in the exhibit 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. Growth stocks of all sizes were in favor, returning about 16% in the quarter. Large core was out of favor. This implies that pure growth and pure value managers should have performed better than their more centric counterparts, like relative value and GARP (growth at a reasonable price).

The dots plotted in the floating bars indicate that S&P performance is near median, and the bars at the bottom of the exhibit show the S&P’s larger company orientation (red bars) versus the total market (blue bars).

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 or her 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 both sector allocation and stock selection were in line with the total market.

Technology and financial stocks were in favor, returning 20.77% and 19.18% respectively. Note also the tight distribution for technology and the wide distribution for financials, indicating the differing ranges of opportunities in these two sectors.

Portfolio vs Peer Group