What is a relative-performance orientation?

Relative performance involves measuring investment results, not against an absolute standard, but against broad stock market indices, such as the Dow Jones Industrial Average or Standard & Poor's 500 Index, or against other investors' results.

Most institutional investors measure their success or failure in terms of relative performance.

Money managers motivated to outperform an index or a peer group of managers may lose sight of whether their investments are attractive or even sensible in an absolute sense.



Who is to blame for this short-term investment focus? 

Is it the fault of managers who believe clients want good short-term performance regardless of the level of risk or the impossibility of the task? 

Or is it the fault of clients who, in fact, do switch money managers with some frequency? 

There is ample blame for both to share.



There are NO winners in the short-term, relative-performance derby. 

Attempting to outperform the market in the short run is futile since near-term stock and bond price fluctuations are random and because an extraordinary amount of energy and talent is already being applied to that objective. 

The effort only distracts a money manager from finding and acting on sound long-term opportunities as he or she channels resources into what is essentially an unwinnable game. 

• As a result, the clients experience mediocre performance.  
• The overall economy is also deprived, as funds are allocated to short-term trading rather than long-term investments.  
• Only brokers benefit from the high level of activity.

Institutional investors should strive to achieve good absolute returns.

Institutional investment process should focus on maximizing returns under reasonable risk constraints.  

If more institutional investors strove to achieve good absolute rather than relative returns, the stock market would be less prone to overvaluation and market fads would less likely be carried to excess.  Investments would only be made when they presented a compelling opportunity and not simply to keep up with the herd.

The true measure of a successful investor

The true measure of a successful investor is not a comparison of performance against a stated index, but rather how well a portfolio performs during down markets.


Warren Buffett is unique in measuring himself annually against changes in book value (the simple calculation of assets minus liabilities).  He then compares this annual percentage against the S&P 500 with dividends to determine if he has added value or not. 

Buffett has not only added value.  He has done the remarkable.  Buyiing earnings of companies at attractive prices with outstanding management and with remarkable competitive advantages have all led to mind-blogging increases in book value.

A metric that Warren Buffett never reports or comments on is the actual market price of his stock.  He reports the value of his business because he can control purchases, ongoing management, asset purchases and sales, liabilities, and other things that affect changes in book value.  Conversely, he ignores the share price because often it has nothing to do with what is going on inside the business.

Value is inside.  Price is outside.

Return Objectives

Absolute return objectives sate the percentage return desired by the client.  The return may be expressed on a real or nominal basis.

Relative return objectives express the required return relative to a stated benchmark.  A good benchmark should be investable i.e., an investor should be able to replicate it.

The return objective may be stated before or after fees and on a pre- or post-tax bais.

It could also be expressed in terms of a required return, that is, the amount an investor needs to earn over the investment horizon to meet a specified future goal.

The portfolio manager must ensure that the client's return objective is realistic in light of her tolerance for risk

Central elements to a Value Investing Philosophy

The three central elements to a value investing philosophy:

1) A "bottom-up" strategy

2) Absolute (as opposed to relative) performance

3) A risk averse approach

Bottom-Up Investing

Most institutional investors use a top-down approach to investing. 

• That is, they try to forecast macroeconomic conditions, and then select investments based on that forecast. 
• This method of investing is far too prone to error, and doesn't allow for a margin of safety.
• For example, a top-down investor must be correct about the big picture, draw the correct conclusions from that big picture prediction, correctly apply those conclusions to attractive areas of investment, correctly specify specific securities, and finally, beat other investors to the punch who have made the same predictions.
• In addition to these challenges, top-down investors are buying based on concepts, themes and trends. 
• As such, there is no value element to their purchase decisions, and therefore they cannot buy with a margin of safety. 

On the other hand, bottom-up investors can apply a margin of safety and face a limited number of questions, e.g. what is the business worth, what is the downside etc.

Absolute Performance

Institutional investors are judged based on their performance relative to their peers or the market. 

• This results in a short-term investing horizon.
• Thus, if an investment opportunity appears undervalued but the value may not be recovered in the near-term, such investors may shun such an opportunity. 

Absolute investors don't judge themselves based on their performance to the market, which results in a short-term investing horizon. 

• Instead, they focus on investments that are undervalued, and are willing to wait for that value to come uncovered.

Risk

In the financial industry, returns are expected to correlate with risk. 

• That is, you cannot generate higher returns without taking more risk. 
• Downside risk and upside potential are considered to have the same probability (an implication of using beta, a measure of a stock's volatility versus the market).

Value investors think of risk very differently. 

• Downside risk and upside potential are not necessarily the same.
• Value investors seek to exploit this key difference by buying stocks with strong upsides and limited downsides.

Read:

Seth Klarman - Margin of Safety

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

Absolute Return Investing

At the other extreme, there are funds that are not benchmarked.  Instead, their objective is to target a particular return with a given risk level and a strong focus on capital preservation.  This strategy is called "absolute return investing" and is largely adopted by hedged funds.

Absolute return managers can invest in any asset class anywhere in the world.  Therefore, if the S&P 500 is falling significantly, absolute return managers can choose to allocate their money to a more favourable market like Europe and Asia, or even raise cash, to invest in another asset classes or invest short.

In a bull market, absolute return portfolios can under-perform against relative return portfolios.  However, in the longer term when markets go through the cycle of boom and bust, absolute return portfolios tend to outperform as big losses are avoided during the bear periods.

Benchmark Investing: Relative Return Investment Strategy

Fund managers who track a benchmark closely have a relative return investment strategy.

Their asset allocation strategy and stocks picked are close to their chosen benchmarks.  They then value-add by overweighting or underweighting stocks that they feel would help the fund outperform.

Investors who question the existence of fund managers, who consistently underperform their benchmark, have been advised to invest via index funds instead as they charge lower on management fees.

There are also managers who vary quite significantly from their benchmark.  With a larger tracking error, they can outperform it by quite a wide margin especially in volatile times.

However, when a broad based market heads south significantly, a fund that is benchmarked, like the S&P 500, will usually find it difficult to avoid losses.  

• Firstly, this is because the fund is mandated to stay invested in stock under the index.
• Secondly, the fund manager cannot stay invested in only a few profitable stocks, as they typically do not invest more than 5 percent of their portfolio in a stock or a group of related companies.

Growing at 15% a year - what does this entail?

To achieve a 100% gain in your investment over 5 years, the initial capital has to grow at a compound rate of 15% per year. This means that an initial $100 investment will be worth:

$1.15 at end of year 1,
$1.33 at end of year 2,
$1.52 at end of year 3,
$1.75 at end of year 4, and
$2.01 at end of year 5.

Though the fund managers usually benchmark their fund performances to a certain index, most individual investors should look at the absolute return.

The return on your investment is unlikely to rise in a straight-line upwards. Volatility in the return is to be expected. The return spurts over certain times, declines over certain times, and remains unmoved over certain times.  However, the return over a long time is less volatile and generally relates to the earnings of the business of the invested stock.

What does 15% per year looks like in real-time? Excluding the dividend yield from the calculation, it is actually an average of 1.25% per month appreciation in the share price. The 15% may be returned in a consistent manner or there maybe periods of spurts delivering part or all the returns over many short periods. Do not get disheartened if a stock moves only 1% or 2% per month, it is the consistency in its return that adds to a big return. On the other hand, do not be overly excited by the big returns over a short period. For the long-term investors, it is more important that over a long time, the price of the stock reflects the improving earnings fundamentals of your selected stocks.

To double your initial investment in a stock in 5 years means also selecting a stock that will double its earnings in 5 years. For those who are directly in business, to grow a business consistently over many years is indeed very challenging. The matured large companies are less likely to deliver such growths. Therefore, for those investors seeking such growth rates in the earnings of their stocks, they will need to look at mid-cap stocks or smaller companies where growths can be faster in the early stages of their business life.

It is not difficult to make 7 or 8% returns yearly in your investment in stocks.  However, to grow at 15% or more, this can be very challenging indeed, but not impossible even for the non-professional investors.

Individual investor should focus on absolute returns from their investment.

The fund manager tends to benchmark the return of the fund to an index. However, for the individual investor, it is better to focus on absolute return on their investment. Their first priority, of course, is not to lose money.

It is not difficult for the average investor to get a modest absolute return from the stock market consistently over a long period. Through careful selection of only a few stocks, this is easily achievable.

However, the investors, with better knowledge, skills and the willingness to spend time doing the homework, can hope to better this modest absolute rate of return consistently over a long period.

The returns are volatile over the short term. However, over the long term, the returns will reflect the fundamentals of the invested companies. Adopting the simple strategy of investing in good quality companies bought at bargain or reasonable price, the absolute returns over the long term should predictably and hopefully be positive.

Those with the ability to sense or value the overall market can employ tactical dynamic rebalancing in their portfolio management. They can allocate a bigger percentage to equity when the reward/risk ratio is more favourable during the depth of the bear market and by investing less into equity when the reward/risk ratio is less favourable during the height of the bull market. This strategy reduces the risk of big losses during a bear market. Implementing this strategy will be challenging and can only benefit those with good rational understanding of the valuation of the overall market.

Why do people lose money in the stock market?

Graham defined investment thus: "An INVESTMENT OPERATION is one which, upon THOROUGH ANALYSIS, promises SAFETY OF PRINCIPAL and a SATISFACTORY RETURN. Operations NOT meeting these requirements are speculative."

Maybe these people are gambling or speculating rather than investing. Perhaps, they thought they are investing when in fact, by Graham's definition, they are gambling or speculating.


(Absolute return, Relative return, Short term, Long term)

Where is your focus in your investment returns?

Are you focussed on absolute return and capital preservation?

Or, are you more focussed on relative return to a certain benchmark?

Perhaps you are more focussed on one or the other at different market environments. Certainly these are food for thoughts.

But then, it was also ridiculous to an individual investor, for his fund manager to talk about beating a certain market benchmark during the recent severe bear market when the absolute return of the fund was negative and the capital was also down by a large amount!