Despite good performance numbers, a manager finds ugly chasm of confusing discrepancies in rankings by consultants
By Randall R. Eley
I was minding my business earlier this year, when suddenly I got pulled into the mysterious database dysfunction gap.
My tale starts innocently enough. One month earlier this year, I filled my calendar with typical portfolio manager duties. I compiled and analyzed performance numbers, filed reports and, to cap it all off, scheduled meetings with my big institutional clients.
I was honestly looking forward to those gatherings, if only to report just how well I had invested the pension money entrusted to my firm. I had good news, if I do say so myself. The large-cap value portfolios under my direction had recorded good long-term numbers and a rather healthy 2003, too. For the three years ended Dec. 31, the average annual return of my portfolios was, net of fees, 1.9%, six percentage points ahead of the S&P 500. The 4% net figure I posted for the five-year period surpassed the benchmark by nearly five points per annum. My 10-year 12.1% net a year again outdid the S&P 500's 11.1%.
So off I went on my travels. If you've never had the opportunity to sit in on one of these sessions, I'll set the scene. I clear 12 hours, fly into another town and hop a cab to the pension fund's boardroom. There, the fund's trustees await me. We sit down and break out my bound reports. I clear my throat and then walk through my performance, while the trustees turn a keen eye onto my ledgers.
Let's not forget the consultants. While the trustees have capable, skilled business minds, they still need backup when it comes to the vagaries of the stock market. On these occasions, they call in reinforcements - consultants that are hired to explain stock market trends and analyze portfolios. Beyond giving an objective take on the numbers, they often play the role of gatekeepers. If they are pleased, they back me. If they aren't, well, you get the picture. Some consultants are independent guns for hire. Others come from big firms, such as Callan Associates Inc. and Wilshire Associates, that go as far as to compile large databases to measure the fruits of my labor.
It was during several such meetings early this year that I noticed something odd. The numbers that seemed unquestionably good to me were not having the impression I thought they would. Rather than being pleased, the trustees and consultants were puzzled.
My performance was not the issue. My ranking was. In some cases, consultants reported that my numbers were strong when measured against my competitors. They quoted Callan databases, which placed my portfolio in the top 27% of my class for the three years prior to 2004, the top 32% for the five-year period and the top 24% for the previous decade. Other consultants argued that my ranking seemed lackluster. They cited Wilshire, which placed my portfolios in the top 49% for three years, 59% for five years and 43% for 10 years. It was confusing. How could portfolios five or six points ahead of the S&P 500 yearly finish in the bottom half of its peer group?
Needless to say, I was flabbergasted at first. I went on to ponder the issue, and after speaking with managers at a few consulting firms, I had my researchers look the matter over. My sleuths discovered a curious phenomenon. The problem, dear reader, lay not in our numbers, but in our databases. The apparent discrepancy that the consultants, trustees and I had stumbled upon was one that expands its ugly chasm every few years. We dubbed it the "database dysfunction gap."
I'll explain. First, understand that database compilers come in two varieties. Some, like Callan, like to box fund managers into snug compartments. As a large-cap value manager, I'm parceled off with a group of 66 like-minded portfolio managers. Callan says the median average cap of the stocks my peers hold is about $59.9 billion, compared to an average cap of $79.7 billion for my portfolio. I'm a slightly different beast to Wilshire and other "broad" database keepers. My class of large-cap value peers includes 318 managers with a median $52.6 billion. Those figures aren't as close as they seem. By my count, 78% of my Callan class has an average capitalization greater than the Wilshire median.
The broad manager groupings have done better of late, as they include "traditional" large-cap value managers like me and managers who also dip into smaller-cap stock pools. Consequently, the broad databases have benefited from the market's infatuation with small-cap stocks. The large-cap S&P/Barra Value index, the yardstick I use to measure my results, rose 31.8% last year, yet the small-cap Russell 2000 Value did even better, at 46%. The Russell 1000 Value, a large-cap index a number of my clients use, saw its bottom half in terms of market capitalization climb 42.9%. It helps to know that the Barra Value's median capitalization is $7.8 billion and just 44 of its 338 stocks are below $3 billion. The Russell 1000's median is $3.7 billion with 299 of its stocks below that $3 billion mark.
Over time, an invisible gravitational pull brings the largest and smallest back toward historic means, and, at the end of a full market cycle, the gap between broad and narrow databases closes. That normally takes three to five years, as boom, bust, bull and bear for both value and growth managers pull the rankings of most funds to rather consistent levels in the various databases. However, one portion of a cycle occasionally stretches - as was the case with small caps from 2000 to the present - causing the leveling process to also take longer. In this case, a complete regression can run as long as three to five additional years, and sometimes longer.
We might also blame collective amnesia for the confusion - and in some cases panic - I have seen in boardrooms. The elongated bull market that sprawled across the 1990s caused us to lose track of the existence of cycles. History shows that large-cap growth stocks were in favor from 1994 through 1999. Small-cap value stocks have attracted the lion's share of investment funds ever since. It follows that large-cap value stocks must eventually have their day.
Market trend distortions snowball, and the longer they last, the more investors believe they will continue indefinitely. Then pressure builds on equity managers of all styles to join the parade.
That's not my charge, however. As a large-cap value manager, I am paid to disregard the rise and fall of the market and specific stock groups. Instead, I serve a well-defined function for pension funds. My job is to beat the market over the long haul, of course, but my role is also to keep to a limited group of stocks and to maintain a set discipline in doing so. I safeguard my clients' capital by buying a portfolio of sound businesses with a median capitalization equaling at least that of the S&P/Barra Value. I bring my clients a steady stream of income with relatively high dividend-paying equities, and cushion their portfolios at times when the market is unsteady. And while I am likely to trail the market during years when small- and midsize companies are the rage, my methodology has prevailed over the long term.
Now that I have hopefully set things straight for my clients, I can also draw a modicum of comfort from experience. Once the crowd heads off to pursue the latest fad, I can seize on the moment. In this latest case, the rush to small-cap and midcap value stocks has left me with a number of opportunities. The same cycle that has turned some of my database rankings upside down will, in all likelihood, move back to the center. And, if I stick to my principles, my long-term numbers will continue to shine.