Risk, Return, and Performance Measurement: A Case of Unrealistic Expectations?

ABSTRACT Client criteria imposed upon active asset management companies to hold only high-quality (HQ) investments in achieving specific Treasury-adjusted spreads and above-average rates of return effectively mandate a passive management policy and can be met only with very low probability. HQ investments do not consistently outperform either medium (MQ) or low quality (LQ) investments over time regardless of whether returns are measured monthly, quarterly, or yearly. Further, both time series and cross-sectional results show that HQ sectors are generally associated with ex post returns that are lower than those for either MQ or LQ sectors. Finally, HQ sectors do not outperform MQ and LQ sectors in consistently surpassing Treasury spreads or crediting rates. These results suggest that periodic evaluation of asset performance in light of such stringent criteria misunderstands the dynamic nature of the market as well as fundamental risk/return relationships. INTRODUCTION Because of extreme competitive pressures during the previous two decades within the insurance industry, narrowing profit margins have substantially increased industry risk and the number of insolvent insurers.1 This increased industry risk not only reflects the cumulative impact of various threats upon the industry over time, but it also reflects the growing success of product innovations such as variable/universal life policies provided by insurers.2'3 Although liability characteristics associated with coverage within the industry are traditionally responsible for the industry's preference for fixed income assets, the challenge for managers in managing fixed income assets helps us to understand why these assets tend to be marketable and liquid.4 In recognition of the need for effective management of these assets, insurance companies (clients) without portfolio management expertise often use the services of outside managers to manage these assets. Unfortunately, clients also often impose criteria upon these outside managers that simultaneously tie their hands and ignore the fundamental ex ante relationship between risk and return. The purpose of this article is to explore the likelihood of meeting such criteria imposed by an actual client upon Conseco Capital Management, Inc. (CCM), a provider of fund management expertise and services, during the mid 1990s.5 In particular, CCM was subject to the following criteria: 1. Achieve above-average total rates of return; 2. Achieve specific spread requirements; 3. Invest in only high-quality grade investments; and 4. Be subject to periodic evaluation of performance. The results of this study are very clear and show that criteria which essentially impose a passive management style upon fund managers and limit them to holding only highquality (HQ) fixed-income investments are unreasonable because such investments are incapable of generating sufficiently high returns consistently over time. Within this study, it is shown that HQ investments will successfully meet these criteria no more than 15 percent of the time. Often, the sole emphasis upon achieving above-average total rates of return relative to some benchmark by clients may result in the failure to achieve specific spread requirements. Further, when spread requirements are strictly determined by the cost of funds, shareholder wealth and firm value may suffer. This suggests that an emphasis placed upon surpassing high benchmark-adjusted total rates of return by clients do not serve as a sufficient condition for achieving the specific spread requirements necessary for sustaining or improving market value.6 BACKGROUND AND HYPOTHESES Prior to 1977, all newly issued debt was investment-grade (IG). In 1977, however, some firms began to issue non-investment-grade (NIG) debt. By 1989, Drexel Burnham Lambert estimated that NIG debt accounted for roughly 25 percent of the total corporate debt market and claimed that superior risk-adjusted rates of return could be earned on such debt. …