How relative and absolute risk investors can improve the structure of their equity portfolios.
Growing up, my sister and I spent summers at our grandparents’ house where one of our favorite treats was fresh sliced tomatoes with sugar on top. Snack time always brought out the fun debate about whether tomatoes are a fruit or vegetable. Without the Internet to render a definitive verdict, we settled on enjoying the tomato regardless of its categorization.
Today we can find out quickly whether tomatoes are a vegetable or fruit. The answer is both! Botanically, tomatoes are a fruit. Culturally and legally, they are a vegetable. In 1894, the U.S. Supreme Court ruled that tomatoes were a vegetable, allowing the U.S. Government to impose a tariff on imported tomatoes, protecting domestic farmers.1
Like tomatoes to farmers and botanists, investors classify risk in equity portfolios differently depending on their point of reference. In its simplest form, there are two types of equity risk: absolute risk and relative risk. Research shows that in an ideal world, investors should prefer to invest 100% in low volatility strategies that minimize absolute risk. However, the overwhelming trend to delegate authority to institutional money managers—who generally focus on relative performance—makes this outcome unrealistic. This issue of Fundamentals explores ways to improve the outcome for both absolute and relative risk investors.
Absolute To Relative Risk
For the first three-quarters of the 20th century, the majority of outstanding equity shares were held by individual investors who focused on total return and absolute risk.2 Individuals tended to purchase blue-chip stocks in a buy-and-hold strategy, banking the dividends on a regular basis. There were few specialized institutional money managers acting on behalf of other investors.3
Investment success was measured by a stock’s total return (dividends paid plus stock price gain) relative to its absolute risk (standard deviation). William Sharpe (1966) formalized the concept of return relative to absolute risk when he introduced the “reward-to-variability ratio”; the formula was later renamed the “Sharpe ratio.” Two changes in the 1970s and 1980s contributed to a shift from absolute risk to relative risk as the frame of reference. The first was the growth of assets in pension funds that led to financial intermediation, and the second was the emergence of passive capitalization-weighted indexing.
Assets invested in plans that outsource investment management (the most notable being public and corporate defined benefit plans and 401(k) plans) exploded from $369 billion in 1974 to $19 trillion today.4 This delegation of investment authority to institutional money managers meant a need to measure the success of these hired guns. The anchor for performance success became the market portfolio—the S&P 500 Index, or broader indices, such as the Russell 3000 Index. Conveniently, in 1973, cap-weighted index funds were developed to offer investors an easy, cheap way to access stocks, emphasizing relative risk investing even more.
Today, the clear majority of equity strategies operate either explicitly or implicitly with an eye toward minimizing relative risk. Indeed, the standard deviation and beta of most managers is very similar.5 Thus, the differentiating factors in manager selection should be excess return, tracking error, and the ratio between the two—the information ratio. If a manager experiences a lot of tracking error and seriously underperforms the index, the manager faces the risk of termination. With the average manager running a tracking error of over 6%, randomness alone puts him at risk of getting fired.6 Three years is typically the longest boards allow a manager to underperform the market before pulling the plug. Portfolio managers are a self-preservation-oriented bunch, so they began to manage their portfolios with an eye on the index and toward minimizing relative risk (tracking error), with less concern for absolute risk (standard deviation).
With the advent of the Fundamental Index® approach in early 2005, investors suddenly had a second implementation option for a relative risk pursuit that sought alpha from a different angle. The Fundamental Index method eliminates “negative alpha”; that is, the inefficiency caused by a cap-weighted index portfolio overweighting overvalued stocks and underweighting undervalued stocks and not rebalancing.