|Simple Performance Lessons You Have Not Learned - Challenge The Status Quo|
|Wednesday, May 30, 2012 20:54|
Half of the active managers should beat their benchmark, yet evidence suggests they do not. That is, evidence contradicts Dr. William F. Sharpe’s acclaimed “Arithmetic of Active Management,” which predicts that managers collectively will earn the benchmark return, with half exceeding it and half trailing it. Clients want performance but they are not even getting a 50-50 shot at it, due in large part to the inability of many advisors to identify skill. That’s because many of you are measuring performance with a ruler – the wrong instrument.
The CFA Institute’s Benchmark Committee issued a report in 1998 that recited a litany of problems with peer groups and advised against using them. However, the institute conceded that most readers were likely to ignore the warning. The report goes on to recommend custom benchmarks. This report has been removed from the institute’s website, but I’d be happy to send it to you.
I agree with the report in large part, and I have created the glue that holds custom benchmarks together with a replacement for peer groups. If you rely on benchmarks (custom or otherwise) you'll find that you need to wait many decades to get a significant alpha, even if the manager is reasonably skillful. The "glue" is to instead view performance evaluation as a hypothesis test. We test the hypothesis “performance is good” by simulating all of the portfolios the manager could have held, selecting stocks from the custom benchmark, to create a custom peer group. This gets rid of all the biases in peer groups and solves the waiting problem with custom benchmarks.
A related issue is the creation of custom benchmarks. In his seminal article that introduced style analysis, Sharpe said the style palette should comprise indexes that are mutually exclusive and exhaustive. Russell, MSCI and S&P indexes do not meet these criteria. Plus Russell indexes have two other problems: annual rebalancing and the reliance on Price/Book. The book values of fallen financials in this economic crisis are grossly overstated.
There are two index families that do meet the Sharpe criteria, Surz and Morningstar. Morningstar copied Surz.
The three key due diligence questions are: