When a White Paper Should Be Ignored

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In the investment industry, a claim that is backed up by a white paper takes on an aura of invincibility or unassailability. We at Index Fund Advisors find this to be an unfortunate state of affairs, for as we have previously noted, white papers are not necessarily peer-reviewed, and they are just as likely to contain misinformation as a paper of any other color. An example that comes to mind is a white paper released by Osterweis Capital Management titled “The Role of Active Managers in Managing Downside Risk”. It was nicely summarized in this ThinkAdvisor article.

The Osterweis white paper repeats the tired complaint against index funds that “they cannot provide protection to investors during down markets.” Yes, any fund that is 100% equities (active or passive) will not provide downside protection in a bear market. If an active fund has the illusion of providing downside protection, it is often the result of cash drag which means that when the market recovers, the active fund with the cash drag will likely not have the same degree of increase as a fund without it. The point is that any index fund investor can provide herself the same downside protection by holding a cash or bond reserve. This would be a far more cost-effective approach. As for whether active funds as a whole have provided downside protection, that myth was busted by S&P Dow Jones Indices in their 12/31/2011 Index vs. Active Scorecard.

“Bear markets should generally favor active managers. Instead of being 100% invested in a market that is turning south, active managers would have the opportunity to move to cash, or seek more defensive positions. Unfortunately, that opportunity does not often translate to reality. In the two true bear markets the SPIVA Scorecard has tracked over the last decade, most active equity managers failed to beat their benchmarks.”

Osterweis nonetheless argues that there are three ways active managers protect against downside risk. The first way is to build a portfolio with a high active share. Recall that active share is a quantitative measure of the degree to which a portfolio differs from a benchmark. Everyone would agree that an active fund with a low active share is simply a closet index fund and offers little opportunity of outperformance. However, there are only two ways that a high active share can be achieved—either by concentrating in stocks in the benchmark or by venturing outside the benchmark. A manager that concentrates holdings may be taking on individual company risk which is not a compensated risk factor. A manager that goes outside of the benchmark calls into question whether the benchmark is appropriate or perhaps should be blended with another benchmark.

The second way is to select stocks with an “asymmetrical risk profile”—choosing stocks that are undervalued and avoiding those selling at a premium. Of course, this is what all active managers are supposed to do all the time, and the data shows that they have not achieved success at this endeavor, to put it kindly. Unfortunately, stocks don’t come with labels to tell us if they are under- or overvalued.

The third way is that an active manager should create a “high-conviction portfolio.” The funny thing is that in all these years, we have yet to run into someone who has created a “low-conviction portfolio.” We are not even sure what that would look like. We can only imagine Joe Stockpicker saying something like, “Well I guess I am OK with buying Coca-Cola because I don’t have anything better to spend my investor’s money on.”

To see how well these principles have worked for Osterweis in practice, we evaluated the annual returns of their two funds that have more than five years of data. In fairness, only one of them is an equity fund, but we thought it was relevant to show the results achieved by their bond fund. The funds were compared to their Morningstar analyst-assigned benchmark. The two alpha charts below show that not only was positive average alpha not delivered, the majority of years had negative alpha. For their equity fund (the Osterweis Fund), the overwhelming majority of its positive alpha was attributable to one year, 1999. As for protection in a bear market, the fund beat its benchmark in 2008, only to lose by a wider margin in 2009-2010. Although the bond fund appeared to have substantial negative alpha, it was not found to be statistically significant.



To summarize, none of the arguments made by Osterweis for active management stand up to careful scrutiny, and their own experience does not appear to provide support for it either. Wise investors will ignore this and other similar white papers.