“Tracking error” is the somewhat arcane financial markets term for the amount by which a fund manager will accept as deviation from the return received against investment benchmarks.
Think the ASX 50 or ASX200, the Dow Jones (just 30 stocks), S&P 500, the Nikkei, the FTSE or the myriad of other indexes that investors manage their expectations to.
In a sense it’s also what your average stock trader who sets a portfolio against the local benchmark and loads up on banks, BHP, Rio, Telstra, Woolies and other large cap ASX stocks manages their expectations to.
But tracking error, and the type of portfolio active managers and many private investors construct as they try to stick close to a benchmark, is where they both go wrong, according to Oliva Engel, head of active quantitative equity Asia Pacific at State Street Global Advisors (SSGA) in Sydney.
There is a place for passive index hugging in many investors portfolios. But Engel said that SSGA, one of the world’s largest money managers, takes a very different approach when investing actively for clients – one investors who manage their own account could benefit from.
Adhering to the artificial construct of the top 20, 50 or 200 largest stocks has it benefits, Engel said, including a known set of risk and return parameters limited around benchmark outcomes, “but it also leaves investors vulnerable to risks from major market movements,” she argues.
Engel said investors don’t need to anchor on the ASX300 or some other index. SSGA favours an approach to constructing portfolios that is “benchmark unaware, nimble and explicitly manages risk.”
That means when Engel and her colleagues at SSGA are sitting in the investment committee the discussion is not about index weights. It is a conversation that says “Let’s own stocks we want to own,” Engel said.
More technically, this means SSGA is “focused on efficiently finding growth opportunities where risk is appropriately compensated with expected return, the fund positions investors to gain
from the upside and be cushioned from the downside.”
Practically it means if two stocks are similar, SSGA will take the one with lower risk characteristics. In the end, SSGA ends up with a materially different portfolio allocation than the overall index.
Take the ASX 300’s index. It is heavily weighted in favour of the big banks, BHP, Telstra, Wesfarmers, CSL, Woolies and so on.
But SSGA’s current active Australian equity portfolio is very different.
Of course it has prominent positions in Telstra, and the CBA, but they have a wider array of other large positions in companies including Star Entertainment, Transurban, Duet group, Qantas, GPT, ResMed and Aurizon amongst others.
Engel highlighted that the top six stocks make up close to 40% of the total market capitalisation on the ASX.
The point is that an investor should not be hanging their hat on the performance of just a few big stocks which drive the index returns.
That’s particularly the case, because SSGA says it’s “research showed that it is possible to manage an equity portfolio to deliver strong returns with significantly less risk than the one that is managed to a benchmark under a traditional approach.”
But it does take some work selecting the stocks.
Engel says she and her team “analyse stocks’ return and risk characteristics — using metrics to identify reasonable valuation, growth capability, strong cash flows, and sustainable dividends
— to find these opportunities.”
This is then overlaid with expected volatility to pick the stocks that fit SSGA’s portfolio selection criteria.
That might be a bridge too far for most retail, even self-managed super, style investors.
But the core tenet of Engel and SSGA’s approach suggests that blindly adhering to the big brands, or the top stocks in the economy, is likely to produce inferior returns to an approach which looks beyond the index.