Model Portfolio & SMA Strategists Showcase - Flipbook - Page 30
SMAs & MODEL PORTFOLIOS
A strategy’s three-year alpha figure
calculated from a period that happened
to favor its particular style tilt tells you less
about manager skill than about which
years got selected for the calculation.
And check drawdown alongside return.
A strategy that posted strong alpha
while also taking on dramatically higher
volatility or deeper peak-to-trough
losses than its benchmark hasn’t
necessarily delivered better risk-adjusted
performance, even if the headline return
number is genuinely higher. Sharpe ratio
and standard deviation are the standard
tools for making that risk-adjustment
explicit, and any performance packet
that leads with raw return figures and
buries or omits these should be treated
as an incomplete pitch rather than a
complete one.
One more layer of skepticism worth
applying is that even a benchmark
QUICK MATH
Pre-tax alpha isn’t
after-tax alpha
A strategy with strong pre-tax
outperformance and high turnover can
lose much of that edge once realized
capital gains taxes are factored in for a
taxable account. Ask for turnover and
name count alongside every return
figure. The after-tax number is the only
one a taxable client actually keeps.
Pre-Tax vs. After-Tax Return at Different
Turnover Levels (Illustrative)
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9
Illustrative annual return (%)
benchmark after accounting for the risk
taken to get there, is the metric most
often used to justify a strategy’s fee. It’s
a legitimate concept, but it’s frequently
reported in ways that flatter the strategy
under review. A few habits worth
adopting when evaluating any alpha
claim: Check the benchmark first. A
strategy compared against a benchmark
that doesn’t actually match its risk profile
or sector exposure can show impressive
“alpha” that’s really just a benchmark
mismatch. Check the time period, too.
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8
8
8
7
6
6
4
2
0
Low turnover
Pre-tax return
Moderate turnover
High turnover
After-tax return
CONCEPTUAL ILLUSTRATION based on Jeffrey & Arnott tax-drag research direction, not
specific published figures
comparison that looks reasonable on
paper can mask real differences in
risk. Two strategies labeled with the
identical asset-allocation category, say
two “60% equity, 40% fixed income”
portfolios, can carry meaningfully
different actual risk depending on the
specific securities held underneath that
label. Asset-allocation-level analysis
alone creates a real blind spot here,
since it treats any portfolio matching
a target allocation as equivalent
regardless of what’s actually inside it.
Modern portfolio-analysis technology
increasingly does this comparison at
the individual holdings level rather than
the asset-class level specifically to
catch this, surfacing, for instance, that
one “60/40” portfolio is concentrated
in a handful of large-cap technology
names while another matching the
same allocation label is broadly
diversified across sectors, with very
different risk profiles despite the
identical label. Where this kind of
holdings-level analysis is available, it’s
worth using it before accepting that
two similarly labeled strategies are
actually comparable.
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WHAT MORNINGSTAR’S OWN
RATING RESEARCH SUGGESTS
ABOUT THIS DISCIPLINE
There’s reasonably good evidence
that a disciplined, forward-looking
evaluation process outperforms
chasing trailing returns. On average,
Morningstar’s Silver-rated models,
rated using a forward-looking
assessment of people, process, and
parent rather than trailing performance
alone, have outperformed Bronze-rated
models on a category-benchmarkadjusted basis, while Neutral-rated
models have shown slightly negative
alpha versus their benchmarks. That’s
a meaningful data point. A rating
system built around the qualitative
due-diligence factors discussed earlier
(p. 22), rather than backward-looking
return-chasing, has actually tracked
with forward outperformance.
It’s not proof that any specific Goldor Silver-rated model will outperform
going forward, but it’s real support for
the argument that process-based due
diligence beats performance-chasing
as a selection discipline.
