McGraw-Hill

8 Introduction
ers, who are held to strict account by the need to match the risk and
return of their underlying benchmarks, traditional active managers
are generally given wide leeway to pursue return. This leaves the
door open to cognitive errors and ad hoc portfolio construction,
which can detract from return and add to risk.
Traditional management’s focus on return over risk and se- on
curity selection over portfolio construction can result in portfolios
that are poorly defined with regard to the underlying investment
benchmarks, and this may create problems for clients. Without explicit
guidelines that tie a portfolio to an underlying benchmark, a
traditional manager may be tempted to stray from the fold. A traditional
value manager averse to analyzing utilities, for instance, m
simply exclude them from the portfolio. Or, if value stocks are currently
underperforming, the manager may seek to bolster portfolio
performance by buying some growth stocks instead.
A client using this manager cannot expect performance consistent
with value stocks in general. If utilities outperform, for example,
the value portfolio that excludes this sector will lag the
benchmark. Nor can the investor comfortably combine this manager’s
portfolio with, say, a growth stock portfolio; if the value portfolio
already includes growth stocks, the investor’s overall portfo
will be overweighted in growth and overly susceptible to the risk
that growth stocks will fall out of favor. Thus lack of discipline in
traditional active management’s security selection and portfolio
formation processes can be compounded at the level of the client’s
overall investment funds.
Given their heavy reliance on human brainpower and their
primary focus on return, with little consideration of risk control, traditional
active approaches tend to suffer from a lack of breadth and
a lack of discipline. These shortcomings, in turn, can translate into
diminished return, increased risk, and inconsistencies in portfolio
composition and performance. Perhaps it is for these reasons that
traditional active portfolios have not tended to turn in superior p
formances.
It is, in any case, difficult to ascribe that failure to the utter efficiency
of capital markets. In fact, the very shortcomings of traditional
management would seem to foster inefficiencies in price
setting-and opportunities for investors savvy enough to exploit
them. ’