A particular insurance company’s investment department measures stock performance against the S&P500 index on an annual basis. The portfolio is long only with no derivatives. The portfolio manager eases into new positions and takes smaller positions outside of the index. The department operates on a monthly trading schedule where all trades for the next month are set within the last week of the current month. Regardless of how much the portfolio outperforms its benchmark, full bonuses are paid based on the trailing three years of performance. This compensation plan is ridiculous for any institutional or individual investor paying for active management and the following is a short example of why that is true.
Imagine that we need to improve performance over the next month or so and identify two stocks for possible purchase. Both have sufficient liquidity with attractive fundamentals and good management but one is a small cap stock outside of the index and the other is a large cap stock in the S&P500. Using multiple valuation methods, we determine that the small cap stock is cheaper than the large cap stock and therefore has a higher expected return. The small cap value stock is also likely to have greater price volatility than the large cap index name. This is intuitive if we assume that over the long term, all stocks revert to some constant information ratio. With a greater expected return, we would assume greater price volatility relative to the large cap stock.
If this were your portfolio and you wanted to maximize long run returns, you would prefer to buy the small cap stock. Unfortunately, this is not what the portfolio manager or equity analyst would like to do. The portfolio manager is primarily concerned with risk. He believes that initiating a new position in a small cap stock is riskier than adding to an existing position in the large cap stock in the index and he is right in the sense that it will increase tracking error due to the higher price volatility of the small cap stock combined with being outside of the index. He is also wrong in the sense that a larger tracking error is only a problem if you are buying more stocks with negative alpha than with positive alpha. I will also be generous in assuming that the portfolio manager does not believe that holding a stock in the past reduces uncertainty in future returns. This is a industry wide problem to be addressed another day. The equity analyst will also prefer the large cap stock to the small cap stock even if his/her compensation is completely performance based. The reason for this is that the position size that the portfolio manager is willing to take is insufficient to provide any meaningful performance improvement. Therefor, it is better to get a small performance boost from a larger position in an index stock than a minimal performance improvement from the small cap stock.
Ultimately, this results in a mediocre enhanced index fund run by overpaid managers. People who make their career on this business model will argue that the portfolio is a broadly diversified, actively managed, low risk, blah blah blah. I usually don’t catch the rest due to the amount of quacking emanating from their non-indexed index portfolio. The bottom line is that if over 90% of your investments are inside the benchmark index and your tracking error is infinitesimal, you are running an index fund and should be paid accordingly. For more articles on the unintended consequences of performance benchmarks, please refer to Beating the Market Part 1 and Part 2.