Latest / The Issue at Hand by Madison Investments / Skill or Luck? Measuring the Value of Active Management
Transcript
- speaker-0: But if you have to take a lot of risk to achieve performance, you might be taking risk that's really correlated with other parts of your portfolio. speaker-1: Welcome back to the issue at hand. I'm joined again by Mike Sanders. How you doing, Mike? Doing good. So before we get started today, I wanted to quickly recap the ⁓ first two topics that we've covered in the issue at the issue at hand. And of course I encourage you to go back and always listen to those episodes. So first, ⁓ what we covered were the major risks of fixed income and how you and your clients should have those conversations, what you should be looking for. The second episode we covered active versus passive. That great debate. How they differ on the types of risks and what considerations you and your clients should kind of work through when evaluating what is best for them. So now let's transition to what we're gonna talk about today. Today we're gonna cover how do you evaluate that manager. How do you quantify, how do you, what do you look at when you're looking at an active manager? So what we're gonna do today is along Mike's gonna help me cover this, is we're gonna cover the risk and return metrics. And hopefully we're gonna come up with a step by step process for understanding why a bond manager performed the way that they did. So Mike, I guess with that backdrop, how about you set up the first topic? speaker-0: Yeah, so you know, I think it just comes back to risk management. I think to be a good investor, I think you have to be a good risk manager. I think they go hand in hand. And what we really kind of wanna show in this this episode or discuss is how, you know, managing risk can translate in performance into performance and then how there's specific statistics that one can look at. that allows you to assess the risk management and the performance and why just looking at performance alone maybe doesn't tell the whole story when you're kind of evaluating what type of manager you want to use. speaker-1: Well I think you kinda threw it in the good one is when you're not just looking at performance. So I think what that means is or at least how I'm interpreting it is we should dig into the why. How did the manager, I guess, generate this alpha? Are they using, I don't know, low quality credit? Are they using derivatives? What are some of the things that we should be looking for then? speaker-0: Yeah, yeah, there's a lot of different ways that a manager can generate performance, like you said, high yield allocations, ⁓ duration management, d ⁓ derivatives, ⁓ you know, th there's ⁓ a lot of levers a manager can pull, those fill those rich fixed income risks that we discussed. And again, each one of those securities or asset classes kind of has their own risks in a way. And then that translates into all of those in generated that performance and then translates into all those statistics that we want to discuss, right? Volatility, alpha, tracking here, inflammation ratio, all of that can be is derived based on the risks these managers want to take. And I think again, the overarching decision from a ⁓ an an investor's perspective is is the risks that the manager is taking in your fixed income portfolio, how is that relating to risks you're taking in other places in your asset allocation? I think it has to go hand in hand when you're evaluating what kind of a manager you want to use. speaker-1: Well then let's dig in. I will so what's a couple of things that you just mentioned in there, I think that we need to explain to people and one of the ones that I want to focus on is gonna be information ratio. I wanna talk about tracking error. And then I think we need to also ta touch on one of the in the past episode we talked about the differences in the benchmarks between equity benchmarks and fixed income ba benchmarks, and I relate that to how people think about beta. So let's start there on beta. How should Clients, how should advisors be talking to their clients about beta when it comes to fixed income portfolios? speaker-0: The easiest way to think about Beta and the t construct of of a fixed income portfolio, just think about an entire corporate bond portfolio. In theory or in reality, a lower quality or high yield when spreads are tightening or the market's doing well will move a lot better than what maybe an A-rated or double A rated corporate bond would be. So in theory, they have more beta. It's the same concept as a more volatile or maybe a little more volatile stock versus the the rest of the market in in broad in broad terms. And so When you think about taking on beta risk, it it and a way to think about it in fixed income is is maybe allocation to layer of quality credit versus the overall template bond market, or you could relate that to maybe mortgages or other securitized product as well. That that's the best way to kinda think about speaker-1: That makes sense. I think it it's just ⁓ again, when we're talking about exposure to the market, we need to know are we going on the letter lower credit quality side or we're doing the higher credit? That makes sense. Correct. I guess I don't wanna I don't wanna get in the weeds too much because the one I do wanna focus on, what I think most active managers kind of focus on, is information ratio. So can you touch on what that is and how clients should be, I guess, looking at that? speaker-0: Yeah, I think it and I and from our perspective I really do think that's one of the more important ones to focus on. It really is a way to describe or view the amount of excess return a manager is is achieving, which again is the goal of active management is to outperform whatever benchmark you're against, but also to to measure that against how much risk you've taken to to outperform ⁓ that benchmark. So You know, you generate a hundred basis points a year in and ⁓ an excess return or alpha, but there's obviously a risk associated with that excess return. And the information ratio kind of balances those two numbers out to give you a statistic that says, well, for per unit of alpha, every basis point of alpha it costs you this much ⁓ in risk. speaker-1: I mean I I I g I understand that, but I think if I wanna break it down, give me the formula. Essentially it is what is your active return over your active risk, right? How my return is to the benchmark versus what the vo the risk is that I'm taking with regard to the benchmark. Is that fair? speaker-0: Correct. Yeah. I mean i if you put numbers into it, if it's a hundred basis points of alpha, ⁓ but you took fifty basis points of active risk, you'd have a information ratio of two. And that's the that's how you think about it. speaker-1: And I guess when we're looking at this as a skill or something that that we should be looking at, this is just yet another tool that a client or a financial advisor should be utilizing to evaluate managers in their portfolios, right? speaker-0: Correct, correct. Because again, you know, generating excess return and alpha is is is is doable when you take a lot of risk. But if you have to take a lot of risk to achieve performance, you might be taking risk that's really correlated with other parts of your portfolio. And so that's why I think it really does matter. Information ratio is is is a one s singular number, but you do have to go a little bit deeper and thinking about what the manager owns or how they how they manage those four in ⁓ risks in fixed income. ⁓ and and it's it's a combination of everything. Again, just looking at alpha can get in trouble by doing that. If you just look at information ratio, you can get in trouble by looking that. I think it's really a combination of looking at everything and seeing how the process that a manager uses to generate performance relates to an overall asset allocation. speaker-1: No, that makes sense. I mean, at the end of the day, it's not gonna be one thing does solves everything. You need to have a combination of things. Now, if I'm if I'm a client and now I kind of want to break it down to how do I wanna evaluate manager A versus manager B? Let's let's try and put let's try and put terms on this. So if I have manager A is generating high returns one year, negative returns the next year, but has an information ratio of about point one versus a manager not as high up, not as low down. Down, but has an information ratio of.5. How should I go about evaluating manager A versus manager B? speaker-0: Well, again, it doesn't there's no right or wrong answer for this, right? If if if an investor is comfortable with maybe more expected excess returns, but having more volatility, that's fine. If they want more consistency, that's another decision to make. ⁓ you know, it Going back to it being a good or bad number, I mean you think about, you know, private credit and and and firms being able to mark to market their own portfolio, which dampens their volatility. So you have better performance and an artificially high information ratio, if they quote that number, because they're marking the mark, there's less there's less trading. That's a way that you could have a really high information ratio and and it's not really a true representation of manager skill or amount of risk that they're taking. So again, it's it's it's how you value alpha in terms of your all overall asset allocation, what you're trying your goal is, what you're trying to achieve. speaker-1: Well, I think you just also made a great point is when we're looking at information ratio, yes, you want to go with the higher information ratio, but you also need to understand how was that information ratio achieved? I think that's that's a nice point to put. I wanna use maybe some real world examples. So if I'm still in this phrase of manager A versus manager B, how would they do in two thousand eight? How would they do I guess twenty twenty twenty two when rates started to come up? How should we evaluate those two managers during those periods? speaker-0: Yeah, I mean I think looking at if if you were truly trying to assess the two different managers, you know, looking at periods of volatility and sh and seeing how the managers up s up down capture ratio would be a great way to do that. ⁓ performance in good markets, performance in bad markets. ⁓ those are other levers that you can h pull in terms of assessing a manager's performance. most likely, you know, higher information or lower information ratio when volatility hits the the standard deviation of their alpha probably widens significantly. It could be down a lot versus a benchmark. Yep. Versus the higher information ratio, most likely, not all the times, but would probably have a much tighter performance pattern versus the benchmark. So I think that's again, it it's not a broad statement, but in general that's these are the maybe the th the ways to think about that. But again, other ways to look at manager performance I think really the key is is to make sure you understand how they're generating that performance and are you comfortable with the generating of the performance and then how that relates to the actual performance statistics and the all and the different ways that you measure it. speaker-1: Well, that's a good point. I think so let's just let's just put a ribbon on that. I think what you're saying is some of the questions that we should be asking is where did the performance come from? What risk generated that performance? Is there consistency to that performance? Like are we looking at long periods of time? Is it short term? How does that manager perform in difficult markets? And then I guess does the manager's strategy, does the manager's views align with what's going on with my client's risk tolerance? I think those are some of the things that when I'm listening to you talk, I think that's the framework that people should walk away from. What do you think? Yeah. Okay. Well, I think that's a I think it's a great place to end. I think we've covered enough things. So for more information ⁓ and disclosures, please visit Madisoninvestments.com. If you haven't already, please subscribe to the issue at hand. You can find us at YouTube, you can find us on Spotify, Apple Podcasts, and thank you for tuning in. speaker-0: Hundred percent. speaker-1: Take care.