Harry Longterm, portfolio manager, had good reason to be proud of the performance of his client’s pension portfolio. On the other hand, he was troubled by the fact that it actually outperformed the market in only 11 of the past 20 years. How could he make his short-term performance more consistent?
According to Charley Broadview, a consultant in performance measurement, the pension portfolio had an alpha of one per cent and a residual standard deviation of eight per cent — a fancy way of saying that the portfolio had one chance in six of lagging its average market-adjusted performance by eight per cent or more in any one year. Broadview deduced from these numbers that Longterm’s chance of beating the market in any five-year period was roughly three out of five.
On the other hand, relatively few portfolios maintain a positive alpha of one per cent for 20 years. Although lots of portfolios will do five per cent better than the market in a given year, the same ones don’t succeed year after year. Broadview suggested that, instead of abandoning his successful approach to search for an even higher alpha, Longterm should consider a four-part program: (1) Pay as much attention to minimizing diversifiable risk as to maximizing expected return; Longterm could probably reduce his residual standard deviation from eight to five per cent without diminishing his alpha. (2) Do everything possible to pare transaction costs; a 25 per cent per annum reduction in transaction costs would increase Longterm’s chance of beating the market over five years from six to seven out of 10. (3) Keep the portfolio correctly balanced between equities and fixed income securities, adjusting promptly for changes in the client’s circumstances. (4) Carry on a continuing education program with the client; most clients put at least as much weight on their confidence in the portfolio manager as on his shortterm performance.