In his popular book, What Investors Really Want, Professor Meir Statman explains that investors want to play the investment game, and they want to win. They believe their investment advisors can help them win by picking skillful active managers. But the fact is that passive index management generally beats active investing, especially in 2014. That’s because obsolete performance evaluation approaches can’t differentiate good from bad. What’s worse, the bad are picked more often than the good. Have a look at our Infographic.
The key to finding good active managers is accurate performance evaluation that shows who has succeeded. The question “Has this manager succeeded?”can only be answered after a second, more critical, question is addressed: “Relative to what?” Successful manager selection derives from accurate benchmarking. In its Benchmark Subcommittee Report, the CFA Institute recommends custom benchmarks and cautions against the use of peer groups. In other words, the old tools of indexes and peer groups don’t work and should be replaced. Peer groups don’t work because they are loaded with biases, with classification bias causing the biggest problems. Peer groups of hedge funds are exceptionally silly because hedge funds are unique so they can’t be grouped together by definition: “unique” means without peers.
The Institute’s custom benchmark recommendation has a serious shortcoming. It takes many decades to establish statistically significant alphas with custom benchmarks. This problem can be solved by integrating custom benchmarks with scientific universes. Scientific universes create all of the portfolios the manager could have held when selecting stocks from his/her custom benchmark; they’re custom peer groups generated by the science of portfolio simulations. The “Relative to what?” is “Relative to all the portfolios you might have held.”
It’s estimated that current investment manager selections subtract about 200 basis points from performance, whereas contemporary evaluation could add 300 basis points. It’s time that investors got what they’re paying for.
To learn more about Ron Surz, visit him at PPCA, Inc.