27 Feb

Tracking Error

"If you want to have better performance than the crowd, you must do things differently from the crowd."      - Sir John Templeton

Today, we all benefit from vast technological advancements that allow for precision measurement and monitoring of our modern world. Our cars, houses and healthcare are examples where durability or service is vastly improved. This is, in part, by using large amounts of data to make better decisions in the development, manufacturing and marketing of just about everything in which we come in contact.

The area of investing is no different and has also benefited. One statistic that is commonly used to measure performance is tracking error. Its development is to help investors determine the quality of historical performance and is defined as a divergence between the price behavior of a portfolio and the price behavior of a benchmark (http://www.investinganswers.com/financial-dictionary/mutual-funds-etfs/tracking-error-4970).

 

So what's wrong with evaluating relative performance and measuring tracking error? We see a couple of potential issues.

First, the investment industry's experience is that many times, divergence happens to the downside and, therefore, "error" seems to be an appropriate moniker. This is when a portfolio's performance falls short of the benchmark. When the portfolio experiences positive relative performance, it is termed active risk. This is the benefit an investor receives for taking the risk of active management.

Carrying this thought forward, when an investment manager knows that they will be evaluated against a benchmark over various time periods, they may unconsciously construct a portfolio with the benchmark in mind. Slowly but surely, it is common for portfolios to mimic the index it is supposed to track and the error produced is curiously close to the amount of fees that are charged. We want to leave the discussion of choosing an appropriate benchmark for a later communique which, thanks to technology, can get as broad or as narrow as one desires.

Second, a conversation should develop around the active versus passive philosophies of investing. We feel it creates a false dilemma that investors must make a choice between either one or the other. Why not just own the index? Recent trends have shown a significant shift from active management toward index-based mutual funds or exchange-traded funds (ETFs). The proliferation of these products has created a superstore mentality.

A concern we have with this approach is structural in nature. The liquidity and ease of investing in this manner does not necessarily match that of the underlying market. This is especially true for some fixed-income markets.

We feel that both schools of thought (active and passive) have merit and work to create solutions that are the best of what is possible for our clients. On the equity side, there is a cost savings and efficiency benefit to gain market beta inexpensively. There is also a benefit to own stock in well run businesses with strong balance sheets and solid cash flows, as they tend to hold value better when markets break down and economies slow. We wish we knew exactly where the markets were headed, but we don't so we diversify to mitigate risk.

EPIQ Partners builds individual portfolios based solely on the needs of the client that generally fall into one of three objectives: PRESERVATION, INCOME or APPRECIATION. From our perspective, accepting divergence is necessary in investing since we construct portfolios with the objectives of the client in mind rather than an index.

In time, we want our clients to achieve their objectives. Experience has shown us that those objectives are rarely tied to the performance of a particular index. The need to measure results is important and we fully expect to experience periods of tracking error (or active risk) because seldom does the benchmark represent the fundamental goals and objectives of the capital's owner.

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The Community Impact Awards presented by Minnesota Business Magazine were held recently.  Bruce Langer was honored to be a finalist in the Good Leader category: http://www.tigeroakmag.com/minnesota-business-magazine/mar15/#?page=36&z=21.

 

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