Lesson 5 of 7
What a mandate forbids
A manager measured against a fixed benchmark cannot hold certain positions whatever they think. One published paper traces an anomaly to that constraint.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Most institutional money is managed against a fixed benchmark, and the manager is measured by deviation from it rather than by the return itself.
- That measurement makes some positions unattractive to hold no matter what the manager believes about them.
- Baker, Bradley and Wurgler argue that this constraint helps explain why low-volatility and low-beta shares have long outperformed.
The question this course keeps returning to is why informed capital does not correct a mispricing. One answer is that the capital is not allowed to.
What the benchmark changes about a position
Measured on absolute return
- The question is whether the holding is worth owning at this price.
- A position away from the index is neither safe nor risky in itself.
- Cash is a position and holding it costs nothing but the return forgone.
Measured against a fixed benchmark
- The question is whether the holding moves the portfolio away from the index.
- Not owning a large index member is an active position, and a painful one when it rises.
- A low-beta holding lowers expected tracking performance in a rising market, whatever its long-run merits.
The same holding is a different decision depending on what the investor is measured against.
The published argument
Baker, Bradley and Wurgler open by naming the anomaly. Contrary to basic finance principles, high-beta and high-volatility shares have long underperformed low-beta and low-volatility shares, and over 1968 to 2008 low-volatility and low-beta portfolios offered a combination of high average returns and small drawdowns.
Their explanation is institutional rather than psychological. The typical institutional investor's mandate to beat a fixed benchmark discourages arbitrage activity in both high-alpha low-beta shares and low-alpha high-beta shares. A fixed benchmark mandate with a leverage constraint, they argue, causes institutional investors to pass up the risk and return trade-off that low volatility portfolios offer.
Why the constraint bites
The chain, step by step
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The manager is measured against an index, usually weighted by market value.
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To beat it with low-beta holdings, the manager would need leverage to raise the expected return back to the benchmark's level.
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The mandate forbids or limits leverage.
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So the manager buys higher-beta shares to reach the required expected return, bidding their prices up and leaving the low-volatility ones cheaper than they would otherwise be.
The mispricing survives not because nobody noticed it but because the people with the most money are contractually pointed the other way.
What this does and does not give a reader
It gives a class of places to look: parts of the market that a benchmarked, leverage-constrained investor finds structurally unattractive. Very small companies, companies outside the index, and boring low-volatility shares have that character.
It does not give an edge. The argument was published in a widely read journal in 2011, and the previous course in this academy measured what publication does to a documented pattern. A constraint that is public is priced by everybody who is not constrained, and there are many of those.
The honest version is narrower: knowing which investors cannot own something tells you who is not competing with you for it. It does not tell you the thing is worth owning.
Check yourself
What does a fixed benchmark mandate measure a manager on?
- The absolute return of the portfolio
- The deviation of the portfolio from the benchmark
- The number of holdings
Show the answer
Answer: B.
Being measured on deviation makes not holding a large index member an active position, which changes which holdings are attractive.What anomaly do Baker, Bradley and Wurgler examine?
- That small companies outperform large ones
- That high-beta and high-volatility shares have long underperformed low-beta and low-volatility shares
- That value shares outperform growth shares
Show the answer
Answer: B.
They report that over 1968 to 2008 low-volatility and low-beta portfolios combined high average returns with small drawdowns, contrary to basic finance principles.What does knowing about a constraint like this actually tell a reader?
- That the constrained positions are worth owning
- Which investors are not competing for those positions, which is not the same as the positions being attractive
- That the anomaly will continue
Show the answer
Answer: B.
The constraint identifies who is absent from a part of the market. Whether anything there is worth owning is a separate question answered company by company.Sources
- Baker, Bradley and Wurgler, "Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly", Financial Analysts Journal, volume 67, number 1, 2011: the underperformance of high-beta and high-volatility shares over 1968 to 2008, and the argument that fixed-benchmark mandates with leverage constraints discourage the arbitrage that would correct it.
What this leaves out
- The paper's period is 1968 to 2008, in the market and with the definitions it states. Later periods are not covered by it.
- An explanation for an anomaly is not evidence that the anomaly continues, and this one has been public since 2011.
- Mandates differ, and many investors are not benchmarked at all.
- Nothing here is advice about any security or strategy.