The Career Risk of Deviating from Benchmarks
I spent years inside institutional investment firms watching brilliant analysts identify compelling opportunities and then do nothing about them. The low volatility anomaly was perhaps the most frustrating example. Every research team I worked with understood the empirical evidence, yet portfolio managers consistently maintained benchmark-like exposures to high volatility sectors. The reason was not ignorance or disagreement with the data. It was something more structural and personally costly. Tracking error constraints, whether explicit in mandates or implicit in performance evaluation culture, created a powerful disincentive against the very deviations that would have historically improved long-term outcomes.
Defining Tracking Error and Its Consequences
Tracking error measures the standard deviation of return differences between a portfolio and its benchmark. Institutional investors typically face explicit limits on this metric, often expressed as a maximum annualized percentage. I have seen mandates specifying three percent, five percent, or occasionally more, but rarely enough to permit the substantial underweights in volatile growth sectors that a pure low volatility approach would require. When a portfolio drifts too far from its benchmark, the manager receives escalating scrutiny from consultants, oversight committees, and ultimately clients. The consequence is not merely professional discomfort but tangible career risk including termination of the management relationship.
The Asymmetric Payoff of Contrarian Positions
The career mathematics facing institutional managers are brutally asymmetric. Underperforming a benchmark during speculative rallies, even briefly, triggers immediate client withdrawals and employment risk. Outperforming during rational periods provides modest benefits that accrue slowly and are difficult to attribute to skill rather than luck. I have calculated that a manager who avoids high volatility stocks might need three to five years of superior performance to offset the career damage from one year of sharp benchmark underperformance. Given average job tenures in the industry, this creates a rational preference for closet indexing even when the manager privately believes in the anomaly.
Consultants and Peer Groups Reinforce Conformity
The institutional ecosystem extends beyond individual managers to include investment consultants who recommend and monitor allocations. These consultants typically evaluate managers against peer groups and style categories that penalize deviation. A low volatility manager who underweights technology during a rally will appear in the bottom quartile of growth-oriented peers regardless of their absolute performance. I have sat in meetings where consultants acknowledged the long-term validity of low volatility research but still advised against allocations that would produce uncomfortable peer rankings. This creates a self-reinforcing cycle where institutional capital flows toward the very assets that empirical research suggests are overpriced.