60% of all return dispersion is just noise.
What, you may ask, are “noisy” portfolios? They’re portfolios with unintended differences in returns relative to each other or compared to a model or a benchmark. We’re not talking about return differences that result from active bets. We’re not talking about return deviations arising from tax management or attention to costs. And we’re not talking about drift casued by security restrictions, ESG constraints, customized asset allocations, customized product choices, or any other form of customization. No, we’re talking about the drift that has no deliberate cause. It serves no purpose. It’s just noise.
And it’s not good. In electronics, “noise” refers to random fluctuations in a signal. It’s the same basic idea with portfolios. There’s a signal out there. You work hard to research securities and design asset allocations with favorable risk and return characteristics. Ideally, all of your portfolios are on an “efficient frontier” of expected return and risk (meaning there’s no alternate portfolio you know of with higher expected returns with the same risk, or lower risk with the same expected returns). When your portfolios drift, the best case scenario is that they’re just moving up or down the efficient frontier — still optimal, but with the wrong level of return and risk. Much more likely is that they’re just inefficient—riskier than they need to be, with no compensatory increase in expected returns.
So noise hurts your clients. And there’s a lot of noise out there. We estimate that more than 60% of the difference in return between portfolios and their targets is just noise. We know this because when we implement our system to increase rebalancing efficiency, return dispersion collapses by more than 60%, while the level of tax efficiency and (intentional) customization goes up. That is, client portfolios simultaneously become more consistent in their returns and more customized. And this points to the source of portfolio noise. Wealth managers are simply not rebalancing efficiently and effectively.
Whether you’re on a phone call, listening to music — or managing a portfolio — nobody likes noise. The difference is that noisy phone calls are a nuisance; noisy portfolios are harmful to your clients' financial health.
For more on this topic, check out The Three Types of Wealth Management Firms.
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