As I was watching the Heat run the Pacers out of their own building on Sunday night, I got to thinking about the parallels between basketball and portfolio construction.
The NBA is undoubtedly a superstar’s league. It is extremely difficult to consistently compete for championships without one of the league’s best players. Nineteen of the twenty-three NBA champions since 1990 have had at least one member of the first-team All-NBA team on their roster. The last team to win a championship without a member of the first, second or third All-NBA teams was the Detroit Pistons in 1989.
However, having a superstar is a necessary, but not sufficient condition for achieving the highest levels of success in the NBA. Teams must surround their superstars with specialists that complement/enhance the superstar’s talents and allow for success against different types of opponents. Even the best players of all time have had trouble winning until they were united with the right role players. Michael Jordan didn’t win his first championship until Scottie Pippen emerged as an elite player. Jordan also relied on John Paxson to stretch the floor with his shooting touch, Horace Grant to rebound and play world-class defense, Bill Cartwright to guard the elite centers in the Eastern Conference and B.J. Armstrong to provide a spark off the bench.
In summary, the formula for NBA success is simple in theory:
- find a superstar (easier said than done, we will get to this point later)
- surround superstar with complementary, specialized pieces
Some quick examples:
- Chicago Bulls - 2013: Had the perfect pieces to complement their superstar, Derek Rose, but with Rose out for the season with a knee injury the team lost to the Miami Heat in the Eastern Conference semifinals
- Cleveland Cavaliers - 2009: In LeBron James, had one of the best players of all-time in his prime, but lost to the Orlando Magic in the Eastern Conference Finals due to the lack of an inside presence and a solid second scoring option behind James
- My hometown Washington Wizards – 2009-2013: Had neither 1) nor 2) and as a result have lost 277 of 394 games in the last five years
Most NBA general managers looking to build a perennial championship contender prioritize finding the franchise player first due to the scarcity of these types of players (Right now there are probably not more than 10 players that are consensus franchise centerpieces).
In our view, it seems that many marketers of financial products, in the retail channel specifically, advocate the “NBA approach” to portfolio allocation: find superstars then fill out the rest of the roster with role players. The prevalence of this approach becomes evident when reviewing marketing materials for mutual funds. It is rare to find materials that explain how the product should be used within a portfolio or laying out specific behavioral characteristics that the strategy should exhibit going forward. Instead, marketers tend to focus on arguing that a given strategy will consistently outperform its peers on a return basis (superstars). This marketing philosophy is problematic for a number of reasons:
- Incomplete: Return, like points in basketball, may be the sexiest indicator of performance but it is not the only indicator and more importantly does not tell the whole story regarding performance (think volatility, drawdown, correlations, etc. in portfolio management and assists, steals, turnovers, field goal percentage, etc. in basketball)
- Impractical: Vast research has shown that as a whole portfolio managers are not able to attain outperformance over extended periods of time. Intuitively, this makes sense as different groups of managers use independent investment methodologies (i.e. managers that use momentum models vs. value managers) that fall in and out of favor over time. To consistently outperform, the end investor would have to successfully rotate managers, which if possible would eliminate the need for the mutual fund manager in the first place. Put more simply, superstars are very difficult to identify ex-ante (for those still following the basketball analogy, think Sam Bowie over Michael Jordan, Darko Milicic over Carmelo Anthony and Dwayne Wade, and Greg Oden over Kevin Durant)
- Opaque: Without clear objectives other than generic outperformance, it becomes difficult to accurately assess manager performance on an ongoing basis, potentially leading to imperfect decision making. Suppose an investor has a large-cap manager whose fund returns 7.5% with 7.5% volatility during a year when the S&P 500 is up 10% with 20.0% volatility. On a pure return basis, this manager should be fired. Would this be a good decision? Well, it depends. An investor that cares about risk-adjusted returns would probably be pleased. On the other hand, a 22-year old investing through a 401(k), but unable to employ leverage would have probably preferred to just be in an index fund and realize the entire 10% return. A less clear example would be a fund that underperforms by 2% with the same volatility as the index and a correlation of 0.2 to the index. There may be some value to holding the strategy from a diversification perspective. However, it is tough to know without the manager clearly articulating an investment model that specifically targets low correlation to the index. Without this communication, it is impossible to know whether the low correlation is a value-add of the manager or just a temporary phenomenon that occurred by chance and will likely disappear in the future.
I would argue that portfolio allocation should be undertaken using the opposite of the “NBA approach.” Use strategy building blocks that seek to achieve simple, easily defined and evaluated objectives (role players). If the building blocks are combined in an intelligent manner, then the portfolio as a whole can achieve the investor’s objectives even without any superstar managers. If the investor happens upon a few superstars by accident, that is even better.
Examples of Strategy Building Blocks/Role Players
Consider a strategy that allocates between the SPDR S&P 500 ETF (“SPY”) and the SPDR Barclays 1-3 Month T-Bill ETF (“BIL”) with the goal of targeting 10.0% annualized volatility while maintaining a high correlation to SPY. By clearly articulating performance objectives, it becomes very easy to determine client suitability, determine the appropriate place within an overall portfolio and evaluate performance. The product probably makes sense in a retirement portfolio for investors with a lesser need for strong capital appreciation, but that are willing to take some equity risk in order to potentially allow for larger withdrawals going forward. From a performance evaluation perspective, if product volatility ends up being 2.5% or 30.0% or it behaves nothing like SPY than replacing the manager becomes a no brainer.
Another example would be a firm marketing a short volatility fund (for example the VelocityShares Daily Inverse VIX ST ETN (“XIV”)). The firm could focus solely on argument for why the strategy should deliver strong returns (realization of volatility risk premium, upward sloping volatility term structure, etc.). While this is important, the riskiness of the strategy (down 74% from July 2011 to November 2011) together with its use of derivatives may scare away retail investors. Educating investors as to how the product can be used in a thoughtful, responsible way not only benefits the investor but may also increase inflows. The marketing documents could point out that the strategy could be used in tandem with a low beta equity strategy in order to realize the documented low beta equity risk premium without sacrificing absolute return levels for investors that cannot utilize more direct forms of leverage.
More than likely, marketing methods are not going to evolve without clients changing the way they go about evaluating investment opportunities. Clients should continuously question a marketer/manager as to how the strategy should fit into their portfolio and what are specific, concrete objectives to be used in evaluating performance going forward. Focus continuously on building out your portfolio team with the role players that together can best help you to achieve your financial objectives.