More stocks, lower returns

Michaud challenges quant managers’ gospel, promotes different optimizer

BOSTON — Too many stocks spoil returns. At least that's what Richard O. Michaud maintains.

The industry iconoclast is challenging the famous work of Richard Grinold and Ronald Kahn, "The Fundamental Law of Active Management."

The concept is the mainstay of many major quant managers, who collectively manage trillions of dollars in assets.

Messrs. Grinold and Kahn, both senior executives at Barclays Global Investors, San Francisco, wrote in a 1989 Journal of Portfolio Management article that, essentially, a skilled portfolio manager has a greater chance of producing strong returns if he or she is given a greater breadth of opportunity sets with which to work.

Their work was extended in a 2002 article in the Financial Analysts Journal by Roger Clarke, Harindra de Silva and Steven Thorley. They said that removing portfolio constraints by allowing skilled managers to use tools such as shorting and the use of derivatives can increase the manager's "transfer coefficient" — which, essentially is the measure of how much of the manager's skill was incorporated in the returns of the portfolio. Messrs. Clarke and de Silva are investment professionals at Analytic Investors Inc., Los Angeles. Mr. Thorley, a finance professor at Brigham Young University, has worked at Analytic. In 2004, JPMorgan Asset Management, New York, used the articles to validate its "130/30" strategy, a portfolio that is 130% long-only stocks, and 30% short stocks. Firms such as BGI; Analytic Investors; Mellon Capital Management, San Francisco; and Goldman Sachs Asset Management, New York, all have adopted the philosophy in various strategies as well.

Not first time

It's not the first time Mr. Michaud has stirred the pot: In 2001, he lambasted behavioral finance theorists in paper called "The Behavioral Finance Hoax."

Now, Mr. Michaud, who is chairman of New Frontier Advisors, LLC, Boston, is challenging Messrs. Grinold and Kahn's ground-breaking work. In a paper written last July and in industry speeches — including an upcoming appearance at the Quantitative Work Alliance for Applied Finance, Education and Wisdom's Boston chapter — Mr. Michaud has been arguing the theory doesn't work.

In his paper, "The Fundamental Law of Mismanagement," Mr. Michaud wrote: "Consider the analyst suddenly asked to cover twice as many stocks. Given limitations of time and resources, it is unlikely that the same information level can be brought to bear when analyzing each stock … in general, the information coefficient is likely to be a decreasing function of the number of stocks in an optimization universe."

The information coefficient is the mathematical measure of the quality of information that an analyst or portfolio manager possesses.

Mr. Michaud said the theory does not apply to quantitative money managers, either. Quantitative money managers generally use mathematical models that incorporate various pricing factors of individual securities to optimize a portfolio, and generally can analyze a large universe of stocks at a time. But Mr. Michaud said that simply increasing the number of stocks in a quantitatively managed portfolio generally won't produce improved results because there are only so many pricing factors that are applicable to the movement of a stock at one time.

The Fundamental Law of Active Management optimizes a portfolio by calculating the quality of information an investor has, and how much investor skill can be incorporated into a portfolio. The Michaud resampling technique, which Mr. Michaud advocates in his paper, optimizes a portfolio by computing the averages of hundreds of alternative efficient frontiers via a Monte Carlo simulation.

Put simply, the Michaud process calculates the various possible results of a portfolio before choosing the most efficient portfolio. Mr. Michaud also said the main difference between his optimizer and the Fundamental Law is that his optimizer takes in to account estimation error, which is the margin of error between the optimization process and the results of the portfolio.

"Estimation error has been shamefully neglected in this industry for 25 years," said Mr. Michaud in an interview. "The Grinold and Kahn formulas and prescriptions do not take in to account estimation error. When you do, the results are different."

Messages left for Messrs. Grinold and Kahn were not returned.

Some disagreement

Several industry experts disagree with Mr. Michaud.

"I certainly understand (Mr.) Michaud's interest in promoting the business opportunity for his patented resampling methods," said Barton Waring, managing director and chief strategist at BGI. "But there are a number of points that he makes that I think convey a false sense of the theories of Grinold and Kahn … it might be well for him to adapt these techniques to his methods, rather than to make weak criticisms of them."

Mr. Waring added that money managers that do implement the Fundamental Law would only do so if they, in fact, have an extensive array of resources and manpower. "Richard waves this away with the presumption that managers are limited in resources in a way that prevents that. But while many traditional portfolio managers are often limited, managers such as BGI, who use the Grinold and Kahn methods very heavily, continue to add massive resources in their research areas, and continue to enjoy massive gains in their alphas from this effort."

Joanne Hill, managing director of equity product strategies at Goldman Sachs & Co., New York, agreed with Mr. Waring. "In general I think, thanks to Grinold and Kahn, we have come a long way in both identifying the benefits of broadening the choice set of investments, diversifying across investment styles (alpha sources) and varying the time horizon of our strategies. The work of Grinold and Kahn has helped BGI and before that BARRA Inc. (now MSCI BARRA), improve the process of developing quantitative investment products."

‘Don't point fingers'

Ms. Hill added that while the art of quantitative money management still can be improved, "we should focus on advancing the state of the art, rather than pointing fingers and saying money is mismanaged. I certainly won't cast the first stone there."

Ernie Ankrim, chief strategist at Russell Investment Group, Tacoma, Wash., agreed with Mr. Michaud that increasing the opportunity set for fundamental money managers could be a problem. "This is where (Mr.) Michaud starts to get it right," said Mr. Ankrim. "For managers whose security selection is based on in-depth analysis of the prospective firms' financial conditions or product prospects, adding additional securities to consider may not come cheaply, or at the same rate of success."

Mr. Ankrim, however, disagreed with Mr. Michaud in regards to quantitative money managers, saying that, for a quantitative manager, "adding new candidates, and the evaluation of same, does not require a substantial increase in insight or resources. In this case, the firms benefit from a law of large numbers where their added value is not diminished, but the volatility of their success is, as their menu of alternatives increases."

To read the full Michaud paper, click here.