Swedroe: Why Some Anomalies Persist

September 15, 2014

The authors explain: “A typical contract for institutional equity management contains an implicit or explicit mandate to maximize the ‘information ratio’ relative to a specific, fixed, capitalization-weighted benchmark, without using leverage. For example, if the benchmark is the S&P 500 Index, the numerator of the information ratio is the expected difference between the return earned by the investment manager and the return on the S&P 500. The denominator is the volatility of this return difference, also called the tracking error. The investment manager is expected to maximize this information ratio through stock selection and do so without using leverage.

This contract is widely used because it has several appealing features. Although the ultimate investor cares more about total risk, not tracking error, it is arguably easier to understand the skill of an investment manager, and the risks taken, by comparing returns to a well-known benchmark. Knowing that each manager will stick at least roughly to a benchmark also helps the ultimate investor keep track of his or her overall risk across many asset classes and mandates.”

The authors then note that “these advantages come at a cost.” A benchmark makes institutional investment managers less likely to exploit an anomaly. They go on to demonstrate this cost using mathematics. They further show that, in the absence of the ability to use leverage and “in empirically relevant cases, the manager's incentive is to exacerbate mispricings.”

They further observe that: “In practice, our assumption of a leverage constraint seems reasonable. Very few mutual funds for example allow leverage.” To further demonstrate that mutual funds generally don’t attempt to exploit the low-beta anomaly (the lowest quartile of stocks ranked by beta outperforms the highest quartile), they noted that the average mutual fund beta had a beta of 1.10 over the last 10 years.

Finally, the authors concluded: “The combination of irrational investor demand for high volatility and delegated investment management with fixed benchmarks and no leverage flattens the relationship between risk and return. Yet, sophisticated investors are to a large extent sidelined by their mandates of maximizing active return subject to benchmark tracking error.” Thus, the anomaly persists.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.



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