The Cost of Constraint
Institutional Investor (10/02) Vol. 36, No. 10 p.147; Capon, Andrew

A recent study concedes that while rules governing pension funds are necessary, constraints that are overly stringent can also be detrimental. In the report titled, "Portfolio Constraints and the Fundamental Law of Active Management," authors Roger Clarke, Harinda de Silva, and Steven Thorley attempt to show the financial toll common restrictions can have on returns. Building on Richard Grinold's principal of active management, Clarke, de Silva, and Thorley developed a "transfer coefficient," which is the correlation between portfolio weights and best estimates of stocks' future returns. The researchers then calculated coefficients for different groups of investment constraints separately and then together. In short, the paper concludes that the influence constraints wield extends beyond portfolio managers to the market as a whole. One instance where this can be seen is when pension funds order their bond managers to retain only investment grade credits. Such was the case when U.K. telecommunications equipment manufacturer Marconi was downgraded in September 2001, only to have its 2005 bonds drop from 94 cents to 36 cents in one day.


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