When Evaluating Active Managers - Look At The Value Proposition

Every once in awhile, it can be useful to reexamine some ideas that you’ve pretty much accepted as gospel. Many times when you invest other people’s money, these reexaminations are prompted by a client(s) asking “why are you doing this? It’s not working”.

At PCM we have long used The Jensen Portfolio (JENSX) as a large cap growth manager in our managed portfolios. Our initial selection of Jensen came shortly after the collapse of the tech bubble in 2002-03. We were very frustrated with the tendency of large cap growth managers to buy “bubble” stocks. At that time it was Tech but every bubble seems to lead to the same behavior with the growth crowd. I view this inability to say no, no matter how outlandish valuations become, as a serious disease, A disease that eventually leads to gut wrenching portfolio damage. That said, we do need to fill the large cap growth allocation in our portfolios, these stocks do provide a key growth component in a diversified portfolio. Our search was for a manager who could successfully invest the large cap growth universe but who did not suffer from the disease.

Jensen seemed well suited to perform this function in our portfolios. In short, their strict investment discipline has kept them from buying into severe overvaluations. However, there are times when the fund exhibits significant underperformance to its benchmark, the S&P 500. One of these was the late 1990’s when the S&P, powered by S&P’s addition of newly minted large cap tech stocks and its removal of some solid foreign companies to make room for them, surged to dizzying heights. From 1994 to 2000 the S&P 500 grew 25% annualized while Jensen managed a trailing but respectable 21%. Subsequently, from August of 2000 to September of 2002 the S&P fell a breathtaking -22% while Jensen only -4.3%. In general the clients we serve do not mind the upside of bubbles but they very much dislike the downside. Most recently, Jensen has underperformed the S&P primarily due to the fund’s lack of exposure to the energy sector (yet another bubble). Again, Jensen’s investment discipline does not favor stocks, like energy companies whose profits are driven by volatile commodities.

During a recent client review, the client pointed out that over the last 15 years (as far back as our charts go) Jensen has only just matched the performance of the S&P 500. “Why not just buy the S&P 500 via an ETF at a fraction of the cost?” he asked. “Yes”, I pointed out, “but it has given us a much smoother ride and this is worth the extra cost.” After this meeting I was pondering this statement. I’d always assumed that less volatility in fund performance was a good thing even if we just broke even with the benchmark over time. The clients would be happier and I’d have more pleasant client review meetings.

To evaluate this assumption I thought it would be a good idea to quantify the risk reduction by comparing the standard deviation of Jensen versus its benchmark. The latest published Standard Deviation for Jensen is 6.5 (all data from Morningstar) vs. 7.89 for the S&P 500. This represents a 20% reduction in risk! So essentially over the past 15 years, after expenses, Jensen would have equaled its benchmark with 20% less risk. Same return at substantially less risk at no additional expense? I’ll take that proposition every time.

There are two points here that I hope you will incorporate into your own investment thinking. The first is that it is possible to focus too much on fees and expenses to the detriment of your portfolio. I’m willing to pay the extra freight for active management if the value proposition looks promising. In the case of Jensen it does. The second is that when you look for managers for your mutual fund portfolio, look for people with a viable and tested investment strategy that meets your investment goals and whom you trust to stick to that strategy no matter what happens in the market. These are the people that will, over a reasonable time horizon, make you money and allow you to sleep well at night