A Case for Active Management

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RPS
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A Case for Active Management

Post by RPS » Tue May 17, 2011 7:10 am

Is Portfolio Theory Harming Your Portfolio?

http://papers.ssrn.com/sol3/papers.cfm? ... id=1840734

From the Abstract:

"Modern Portfolio Theory (MPT) teaches us that active equity managers who use judgment to make investment decisions won’t be able to match the returns (after fees and expenses) of blindly-invested, passively-managed index funds. Data on returns supports the theory, so it’s no surprise that investors are leaving actively managed funds in droves for the better average returns of super-diversified index strategies. Yet the reality is much murkier than we’ve been led to believe.

"It turns out that the portfolio theories which inspired the creation and popularity of index funds and top-down, quantitatively-driven index-like strategies, are both flawed and impractical. There’s compelling evidence, moreover, that a subset of active managers do persistently outperform indexes."

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Post by Wagnerjb » Tue May 17, 2011 10:22 am

First of all, the author is a guy who set up a one-person investment firm less than a year ago.....so I automatically question his independence. Anyway, I skimmed his article this morning and it appears mighty shallow. He tosses the current risk measurement out the window, but doesn't replace it with a better notion.
Is a relatively concentrated strategy really more risky for the investor? There’s no doubt that the concentrated portfolio will exhibit more volatility on average than a highly diversified one, but as discussed earlier, volatility isn’t a very useful descriptor of risk (all bets are off if you’re talking about short-term money). Without an accurate way to quantify risk we can’t make the generalization. But just because we don’t have a good top-down, historically-based mechanism for understanding risk doesn’t mean that we can’t tell how risky an asset is. If we think that risk is roughly equivalent to the probability of losing money on an investment, then perhaps we should ask, “are you more likely to lose money owning a concentrated portfolio or a highly diversified portfolio?” The common sense answer is that it depends on what’s in each portfolio! Perhaps then the risk in a portfolio is better described by taking a bottoms-up view of the fundamentals of the businesses owned, and how those fundamentals manifest themselves in stock prices, rather than computing the portfolio’s historic variability with respect to the market?
He goes on to say that concentrated portfolios have a compelling track record, but I didn't see a clear proof of that. If anybody can point to one of the studies he references that shows a compelling case where concentrated funds earn higher risk-adjusted returns (with persistence), I would appreciate it.

When he can show a better risk model and when he can point to compelling persistence in risk-adjusted returns of concentrated portfolios, I will pay attention. In the meantime, I remain skeptical that this guy is little more than an investment manager seeking clients for his concentrated portfolios.

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Re: A Case for Active Management

Post by Call_Me_Op » Tue May 17, 2011 10:47 am

RPS wrote: There’s compelling evidence, moreover, that a subset of active managers do persistently outperform indexes."
Put 1000 monkeys to work picking stocks. After 10 years, a subset of monkeys will have persistently outperformed the indexes. Need more be said?
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Post by pkcrafter » Tue May 17, 2011 10:55 am

Thanks for the link. This is not a study, but rather an opinion, and there are problems as mentioned in the following article. All concentrated funds producing alpha will encounter alpha fade at some point.

http://www.thehindubusinessline.com/fea ... 492963.ece
It logically follows that alpha can be generated only through unique strategies. This poses several problems. One, strategies do not remain unique for a long while. As institutions exploit asset mispricing, alpha becomes beta. And, two, active strategies — whether unique or otherwise — are subject to high risk of failing, leading to underperformance.



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Post by RPS » Tue May 17, 2011 11:09 am

Wagnerjb wrote:First of all, the author is a guy who set up a one-person investment firm less than a year ago.....so I automatically question his independence.
Fair point. But his argument should stand or fall on its merits alone.
Wagnerjb wrote:]He tosses the current risk measurement out the window, but doesn't replace it with a better notion.
It seems obvious to me that equating volatility with risk is useful at various points. But it's even more obvious to me that volatility is not risk. His pointing that out isn't negated by the lack of a better measure, especially if part of the argument is predicated upon objecting to the "quantification" of investment analysis.
Wagnerjb wrote:He goes on to say that concentrated portfolios have a compelling track record, but I didn't see a clear proof of that.
The studies he cites are a significant step in that direction, though more research surely needs to be done.
Wagnerjb wrote:If anybody can point to one of the studies he references that shows a compelling case where concentrated funds earn higher risk-adjusted returns (with persistence), I would appreciate it.
If the measure of risk is wrong, any concept of "risk-adjusted returns" based upon it has to be wrong.
Call_Me_Op wrote:Put 1000 monkeys to work picking stocks. After 10 years, a subset of monkeys will have persistently outperformed the indexes. Need more be said?
What evidence do you propose to put forward to establish that Warren Buffett, Seth Klarman, Joel Greenblatt and the like are investment monkeys rather than highly skilled practitioners?

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Post by yobria » Tue May 17, 2011 11:29 am

As mentioned, this is someone's opinion, based apparently on conclusions from a few real academic papers, which the author doesn't bother to fully cite.

It might be worth posting and analyzing those papers, but I can see no value in this article.

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Post by RPS » Tue May 17, 2011 11:41 am

pkcrafter wrote:This is not a study, but rather an opinion....
But an interesting and promising opinion.
pkcrafter wrote:...and there are problems as mentioned in the following article. All concentrated funds producing alpha will encounter alpha fade at some point.
You make a fair point generally, but you are confusing possibility and probability with necessity, I think.
pkcrafter wrote:It logically follows that alpha can be generated only through unique strategies.

If it is possible to buy undervalued assets and sell overvalued assets, the possibility of out-performance (by whatever measure) remains. Copycats will make it harder.
pkcrafter wrote:One, strategies do not remain unique for a long while. As institutions exploit asset mispricing, alpha becomes beta.

That's certainly possible. But it doesn't appear to be destiny (Buffett, Klarman, Greenblatt...), perhaps due to factors being studied in behavioral finance. Good securities analysis is really hard (so many variables) and our emotions make it very difficult to stay the course and/or "swim upstream."
pkcrafter wrote:And, two, active strategies — whether unique or otherwise — are subject to high risk of failing, leading to underperformance.
Fair point (despite the implicit concession that risk is not volatility). The general risk of being wrong is greatly accentuated by the risk of being wrong alone -- that's career risk at its starkest for the manager and substantive portfolio risk for the investor. However, if the manager really is good, the risk premium provided thereby can be exceedingly well rewarded.

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Post by Call_Me_Op » Tue May 17, 2011 11:41 am

RPS wrote: What evidence do you propose to put forward to establish that Warren Buffett, Seth Klarman, Joel Greenblatt and the like are investment monkeys rather than highly skilled practitioners?
It is in the realm of possibility that their results are due to luck rather than skill. Note that Buffet is more businessman than investor in the usual sense. He is clearly good at identifying successful businesses and helping to make them more successful. But he probably cannot beat the market in the usual sense of picking stocks whose price performance is superior to that of the market as a whole.

Again, I point you to my statistical fact relating to monkeys. Would you take my top 3 monkeys and ask me the same question after they demonstrate many years of out-performance? You may ask me what evidence I have that they are monkeys - if you didn't already know they were.

The important point is that it is impossible to predict ahead of time those investment managers who will be consistently successful in the future. That's why indexing is ultimately a winning strategy.

Remember that beating the market is not about picking good stocks (or stocks of good companies). Usually, good companies make bad stocks - unless you bought them before they were good. Good investing is about picking stocks that surprise to the upside, which has an element of randomness to it.
Last edited by Call_Me_Op on Tue May 17, 2011 11:58 am, edited 3 times in total.
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Risk = Volatility ?

Post by Doc » Tue May 17, 2011 11:55 am

It's been many year's since I read Sharpe's CAPM book but if I recall correctly the price/risk efficiency curve and market portfolio were developed using theory and logic and the assigning of the risk parameter to variance came out of a statistical analysis of private portfolio managers . Variance being the variable that gave the best fit.

In many statistical studies people often apply cause and effect to the variables where none is justified.

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Post by RPS » Tue May 17, 2011 12:11 pm

Call_Me_Op wrote:But it is in the realm of possibility that their results are due to luck rather than skill.

I agree that it is possible.
Call_Me_Op wrote:Note that Buffet is more businessman than investor in the usual sense. He is clearly good at identifying successful businesses and helping to make them more successful. But he probably cannot beat the market in the usual sense of picking stocks whose price performance is superior to that of the market as a whole.

I don't see any evidence for this claim. Indeed, the performance of BKB over time suggests otherwise. Buffett takes more or less active roles in managing the companies he buys, but he clearly buys well both as to business potential and price.
Call_Me_Op wrote:Again, I point you to my statistical fact relating to monkeys.
That statistical fact is only meaningful if the EMH is assumed and I see no basis to assume that the EMH and the related ideas of MPT (e.g., risk = volatility) are true (even though they useful at times). I may grant the theoretical possibility of flipping a coin 100 times in a row and getting heads each time. But if it actually happened my first assumption would be that the coin was loaded.
Call_Me_Op wrote:The important point is that it is impossible to predict ahead of time those investment managers who will be consistently successful in the future. That's why indexing is ultimately a winning strategy.
Your claim as to what is impossible remains unestablished. I grant "difficult," but haven't seen nearly enough to conclude "impossible."

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Re: Risk = Volatility ?

Post by RPS » Tue May 17, 2011 12:20 pm

Doc wrote:It's been many year's since I read Sharpe's CAPM book but if I recall correctly the price/risk efficiency curve and market portfolio were developed using theory and logic and the assigning of the risk parameter to variance came out of a statistical analysis of private portfolio managers . Variance being the variable that gave the best fit.

In many statistical studies people often apply cause and effect to the variables where none is justified.
From the article:
One of the most basic, pervasive, and troubling issues with quantitative finance is that it relies so deeply on the idea that risk is embodied in variance from the mean, or some derivative of that measure. When Harry Markowitz first theorized that there was a tradeoff between returns and variance he didn’t directly associate variance with risk, but noted instead that, in financial writings, if risk were replaced by variance of return, “little change of apparent meaning would result.” Amazingly enough, there’s not much empirical “proof” as to why we should use variance as a measure of risk, yet it plays a critical role in almost all large financial transactions. It seems that academicians needed a way to quantify risk to fit mathematical models and they grabbed variance, not because it described risk very well, but because it was the best quantitative option available. But just because it is convenient, and it carries a certain intuitive appeal, doesn’t make it right.

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Post by pkcrafter » Tue May 17, 2011 12:57 pm

Here is a link to an article I wrote on Antti Petajisto's study, in which he claims certain concentrated funds do outperform. There is a link to the study in the article. So far, no academic journal as picked up the paper.

http://portfolioist.com/2010/12/22/new- ... ve-debate/

Here's a study titled "Why Might Investors Choose Active Management" This study discusses alpha fade at length. Bottom line, alpha at the level when the fund is discovered, cannot be sustained.

http://papers.ssrn.com/sol3/papers.cfm? ... gGD6_UYDXw


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Re: A Case for Active Management

Post by Rick Ferri » Tue May 17, 2011 12:59 pm

"There’s compelling evidence, moreover, that a subset of active managers do persistently outperform indexes."
No one is denying this. Over any period there will be active managers who beat their benchmark. The challenge is knowing which managers will do it in the future. That's were analysis consistently fails.

Then, of course, you have the added challenge of picking active managers across multiple asset classes. Here we find that active manager risk is cumulative, not dilutive. The more active mangers you add to a portfolio, the lower the probability the portfolio will outperform a comparable portfolio of index funds.

Over a 20 year period, the probability that a portfolio of actively managed fund will outperform a comparable portfolio of index funds is less than 3%, and then it's not by much.

So, what exactly is the goal of trying to pick managers who are trying to beat the market? It seems like a large waste of time and money.

Rick Ferri
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Post by pkcrafter » Tue May 17, 2011 1:04 pm

RPS wrote:
pkcrafter wrote:This is not a study, but rather an opinion....
But an interesting and promising opinion.
pkcrafter wrote:...and there are problems as mentioned in the following article. All concentrated funds producing alpha will encounter alpha fade at some point.
You make a fair point generally, but you are confusing possibility and probability with necessity, I think.
pkcrafter wrote:It logically follows that alpha can be generated only through unique strategies.

If it is possible to buy undervalued assets and sell overvalued assets, the possibility of out-performance (by whatever measure) remains. Copycats will make it harder.
pkcrafter wrote:One, strategies do not remain unique for a long while. As institutions exploit asset mispricing, alpha becomes beta.

That's certainly possible. But it doesn't appear to be destiny (Buffett, Klarman, Greenblatt...), perhaps due to factors being studied in behavioral finance. Good securities analysis is really hard (so many variables) and our emotions make it very difficult to stay the course and/or "swim upstream."
pkcrafter wrote:And, two, active strategies — whether unique or otherwise — are subject to high risk of failing, leading to underperformance.
Fair point (despite the implicit concession that risk is not volatility). The general risk of being wrong is greatly accentuated by the risk of being wrong alone -- that's career risk at its starkest for the manager and substantive portfolio risk for the investor. However, if the manager really is good, the risk premium provided thereby can be exceedingly well rewarded.
RPS, you attributed quotes to me which I posted from the article. Only your first quote is mine.


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Re: A Case for Active Management

Post by Stonebr » Tue May 17, 2011 1:13 pm

Rick Ferri wrote:
"There’s compelling evidence, moreover, that a subset of active managers do persistently outperform indexes."
No one is denying this. Over any period there will be active managers who beat their benchmark. The challenge is knowing which managers will do it in the future. That's were analysis consistently fails.

Then, of course, you have the added challenge of picking active managers across multiple asset classes. Here we find that active manager risk is cumulative, not dilutive. The more active mangers you add to a portfolio, the lower the probability the portfolio will outperform a comparable portfolio of index funds.

Over a 20 year period, the probability that a portfolio of actively managed fund will outperform a comparable portfolio of index funds is less than 3%, and then it's not by much.

So, what exactly is the goal of trying to pick managers who are trying to beat the market? It seems like a large waste of time and money.

Rick Ferri
Some of us geezers have figured this out the hard way after 30 years of trying. For every Mutual Shares or Fidelity Contrafund account, there were 3 or 4 turkeys that lagged. Overall portfolio returned market minus expenses and taxes. Add the aggravation of reading all those idiotic magazine articles on who was hot and who was not -- "Pick 6 Hot Funds for Summer Sizzle!"

Step into the cool light of cosmic consciousness -- index.
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Post by pkcrafter » Tue May 17, 2011 1:16 pm

Another article: Past Result Really May Indicate Future Performance. One little problem though:
Spiegel and colleagues tested this approach on fund return data from the Center for Research on Stock Prices. They used the Kalman filter to simulate predictions of funds’ alphas and betas for various periods between 1993 and 2000. Funds with the highest expected alphas were then combined in a portfolio whose ensuing performance was compared to that of a portfolio constructed with a traditional static-alpha model. The Kalman filter portfolio, rebalanced every three to six months with the model’s latest picks, did better. “By assuming that an unobservable variable with a known stochastic process drives portfolio holdings, past changes in a fund’s alpha and beta”—which the Kalman filter can extract from historical return data – “can be used to predict their values in the future,” the researchers concluded, although the predictive power seems to fade within six months (which accounts for their frequent rebalancing). To employ the model in real life, Spiegel says, you’d have to move in and out of funds every few months, probably in a tax-deferred account.
http://www.fa-mag.com/component/content ... nt=1&page=


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Re: A Case for Active Management

Post by dratkinson » Tue May 17, 2011 2:23 pm

RPS wrote:...
"It turns out that the portfolio theories which inspired the creation and popularity of index funds and top-down, quantitatively-driven index-like strategies, are both flawed and impractical. There’s compelling evidence, moreover, that a subset of active managers do persistently outperform indexes."
Name 'em.

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Re: A Case for Active Management

Post by Doc » Tue May 17, 2011 2:35 pm

dratkinson wrote:
RPS wrote:...
"It turns out that the portfolio theories which inspired the creation and popularity of index funds and top-down, quantitatively-driven index-like strategies, are both flawed and impractical. There’s compelling evidence, moreover, that a subset of active managers do persistently outperform indexes."
Name 'em.
Glocke, Hollyer, Reardon, Gross to name a few. :lol:

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Post by gkaplan » Tue May 17, 2011 3:45 pm

Not Bill Miller?
Gordon

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Re: A Case for Active Management

Post by yobria » Tue May 17, 2011 4:00 pm

Doc wrote:
dratkinson wrote:
RPS wrote:...
"It turns out that the portfolio theories which inspired the creation and popularity of index funds and top-down, quantitatively-driven index-like strategies, are both flawed and impractical. There’s compelling evidence, moreover, that a subset of active managers do persistently outperform indexes."
Name 'em.
Glocke, Hollyer, Reardon, Gross to name a few. :lol:
Eh, 4/10,000,000 ain't bad I guess. :)

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Re: A Case for Active Management

Post by RPS » Tue May 17, 2011 4:27 pm

dratkinson wrote:Name 'em.
From the article: "Multiple studies indicate that funds which are more actively managed, or more concentrated, outperform indexes and do so with persistence (Kacperczyk, Sialm and Zheng (2005), Cohen, Polk, Silli (2010), Bakks, Busse, and Greene (2006), Wermers (2003), and Brands, Brown, Gallagher (2003), Cremers and Petajisto (2007))."
gkaplan wrote:Not Bill Miller?
What is it about Miller's fund that makes you think it was small and concentrated?

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Re: A Case for Active Management

Post by Doc » Tue May 17, 2011 7:16 pm

yobria wrote:
Doc wrote:
dratkinson wrote:
RPS wrote:...
"It turns out that the portfolio theories which inspired the creation and popularity of index funds and top-down, quantitatively-driven index-like strategies, are both flawed and impractical. There’s compelling evidence, moreover, that a subset of active managers do persistently outperform indexes."
Name 'em.
Glocke, Hollyer, Reardon, Gross to name a few. :lol:
Eh, 4/10,000,000 ain't bad I guess. :)
Hey. it took me all of 2 minutes to come up with the list. I just took Vg non index bond managers with 5 plus years of tenure and added Bill Gross on as a "hunch". :wink:

It is no problem to come us with a subset of active managers who beat the index. It is somewhat harder to come up with the subset who will beat the index in the future but dratkinson didn't think through the question enough to ask the right question. :) And the "right question" can't be answered for another ten years. On the other hand if you want to talk about the probabilty of picking that future outperformer based on the best information we have you can get an answer. Whether the resulting probability is high enough to make up for the effect of the false postive is again another matter.

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Re: A Case for Active Management

Post by Zook13 » Tue May 17, 2011 7:26 pm

Rick Ferri wrote:
"There’s compelling evidence, moreover, that a subset of active managers do persistently outperform indexes."
No one is denying this. Over any period there will be active managers who beat their benchmark. The challenge is knowing which managers will do it in the future. That's were analysis consistently fails.

Then, of course, you have the added challenge of picking active managers across multiple asset classes. Here we find that active manager risk is cumulative, not dilutive. The more active mangers you add to a portfolio, the lower the probability the portfolio will outperform a comparable portfolio of index funds.

Over a 20 year period, the probability that a portfolio of actively managed fund will outperform a comparable portfolio of index funds is less than 3%, and then it's not by much.

So, what exactly is the goal of trying to pick managers who are trying to beat the market? It seems like a large waste of time and money.

Rick Ferri
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Re: A Case for Active Management

Post by RPS » Tue May 17, 2011 10:19 pm

Rick Ferri wrote:Over a 20 year period, the probability that a portfolio of actively managed fund will outperform a comparable portfolio of index funds is less than 3%, and then it's not by much.

So, what exactly is the goal of trying to pick managers who are trying to beat the market? It seems like a large waste of time and money.
The universe of actively managed funds as described by the article (small and concentrated) is so much smaller than the universe of funds that are commonly thought of as active as to make your claim effectively irrelevant. Indeed, the article postulates that large funds with significant diversification, even though allegedly active, won't out-perform.

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Post by dharrythomas » Tue May 17, 2011 10:33 pm

Call_Me_Op wrote:
RPS wrote: What evidence do you propose to put forward to establish that Warren Buffett, Seth Klarman, Joel Greenblatt and the like are investment monkeys rather than highly skilled practitioners?
It is in the realm of possibility that their results are due to luck rather than skill. Note that Buffet is more businessman than investor in the usual sense. He is clearly good at identifying successful businesses and helping to make them more successful. But he probably cannot beat the market in the usual sense of picking stocks whose price performance is superior to that of the market as a whole.

While I agree with the general argument, stock picking is where Buffett made his reputation and most of his money. It wasn't until BKH got too big for parts of companies to have real impact that he started buying companies. He's actually said and his record seems to indicate that he could do better % wise with a small portfolio that with the current size his extreme excess returns are behind him. I don't discount his ability to win, I doubt my ability to pick the next winner.

Harry

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Re: A Case for Active Management

Post by daytona084 » Tue May 17, 2011 11:01 pm

RPS wrote:
Rick Ferri wrote:Over a 20 year period, the probability that a portfolio of actively managed fund will outperform a comparable portfolio of index funds is less than 3%, and then it's not by much.

So, what exactly is the goal of trying to pick managers who are trying to beat the market? It seems like a large waste of time and money.
The universe of actively managed funds as described by the article (small and concentrated) is so much smaller than the universe of funds that are commonly thought of as active as to make your claim effectively irrelevant. Indeed, the article postulates that large funds with significant diversification, even though allegedly active, won't out-perform.
@RPS: We have been through this same discussion countless times. Yes, in hindsight there exist a small percentage of actively managed funds that consistently beat their indexes over a long period of time (say 10 years). What we need is your post from 10 years ago correctly identifying those funds.

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Post by allwin » Tue May 17, 2011 11:33 pm

RPS wrote: That statistical fact is only meaningful if the EMH is assumed and I see no basis to assume that the EMH and the related ideas of MPT (e.g., risk = volatility) are true (even though they useful at times). I may grant the theoretical possibility of flipping a coin 100 times in a row and getting heads each time. But if it actually happened my first assumption would be that the coin was loaded.
Well, actually if you do flip enough coins it is a statistical certainty that you will get a coin that will show head 100 times in a row.

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Post by Rodc » Tue May 17, 2011 11:39 pm

If you are really convinced I'm not at all sure what your point is other than you like to argue. It is not like you are going to listen to anyone here, your mind is made up. It is not like anyone here is going to listen to you either. I see no point. Reminds me of my 10 year old twin boys trying out their rhetorical skills on each other.

I sincerely wish you luck if this is the path you have chosen.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Post by RPS » Wed May 18, 2011 7:55 am

dharrythomas wrote:I don't discount his ability to win, I doubt my ability to pick the next winner.
wjwhitney wrote:We have been through this same discussion countless times. Yes, in hindsight there exist a small percentage of actively managed funds that consistently beat their indexes over a long period of time (say 10 years). What we need is your post from 10 years ago correctly identifying those funds.
You both have raised the key point. I am extremely confident that an equally-weighted index will out-perform a cap-weighted index over the long haul because a cap-weighted index will -- of necessity -- be prone to bubble risk. I am highly confident (but less so) that a fundamentally-weighted index will do even better for the same reason (and more so). Properly constructed (huge caveat, I know), a value weighted index should do better still, but my level of confidence is decidedly less strong since, as Keynes famously put it, the market can be irrational longer than one can remain solvent (late 90s anyone?). A small and concentrated portfolio has the best possibility for the highest returns, but the margin for error is quite high and our ability to identify the right manager(s) is highly questionable.
allwin wrote:Well, actually if you do flip enough coins it is a statistical certainty that you will get a coin that will show head 100 times in a row.
I said as much. But if I saw it happen, I would assume the coin was loaded unless and until shown otherwise.
Rodc wrote:If you are really convinced I'm not at all sure what your point is other than you like to argue. It is not like you are going to listen to anyone here, your mind is made up. It is not like anyone here is going to listen to you either. I see no point. Reminds me of my 10 year old twin boys trying out their rhetorical skills on each other.
We are essentially hard-wired to confirmation bias and, when strongly held beliefs are involved, being anything like "objective" is nearly impossible -- for all of us. But I know that and, as a consequence, try to check and test my strongly held beliefs and commitments all the time. I frequently change my mind. I don't come here for the echo chamber. I come here to try out and test ideas. I try to do that in a fair and respectful way. Why do you seem to suggest that there's something wrong with that?
Rodc wrote:I sincerely wish you luck if this is the path you have chosen.
I think you're on to more than you may know with this comment. If Bogle is right, our investment success is primarily and fundamentally based upon luck. He may be right, but I hope not.

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rps

Post by larryswedroe » Wed May 18, 2011 8:04 am

The studies you cite are basically flawed, especially the Petijisto one. And even Wermers recanted saying his result was a false discovery (was really a result of a random outcome), if my memory serves. You can read about the problems with Petijisto study (which IMO is why no journal has picked it up) here

http://moneywatch.bnet.com/investing/bl ... newer-post

prior day's post also discusses the paper

Finally note if the only one's that win are high active funds that are very small here is what happens, by the time you know they have been successful for long enough period, cash will flow in following the good performance and it won't be so small and the alpha will go away, even according to the study's results, let alone theory which says it should go away (see Berk's 5 Myths of Active Management)

BTW-concentrating is the only way to really have chance to win, but there is no evidence to my knowledge that it actually works, as evidenced by studies on focus funds for example:

Does concentration of risk improve returns? Travis Sapp (Iowa State University) and Xuemin (Sterling) Yan (University of Missouri–Columbia) sought the answer to that question in their 2008 study, “Security Concentrations and Active Fund Management: Do Focused Funds Offer Superior Performance?”1 Their database covered the period from 1984 through 2002, and contained 2,278 funds comprising 16,399 fund-years. The study excluded funds with less than 12 holdings and as well as those with less than $1 million in assets. The following is a summary of their findings:
• There was no evidence that focused funds outperform diversified funds. In fact, after controlling for other fund characteristics, funds with a large number of holdings significantly outperformed funds with a small number of holdings both before and after expenses. In other words, fund performance is positively, not negatively, correlated to the number of securities in the portfolio.
•The quintile of funds with the fewest holdings realized an economically and statistically significant annual three-factor alpha (return above benchmark, accounting for the exposure to the risks of the overall market, small stocks and value stocks) of negative 1.44 percent.
•At the one-year horizon, the buys of focused funds underperformed their sells by 0.3 percent.
•Focused funds have significantly higher return volatility and tracking error to benchmarks. Investors were taking greater risk while earning lower returns.
•Focused funds held considerably larger cash positions, 12.8 percent versus 7.8 percent for diversified funds. Cash acts as a drag on returns for equity funds.
•The attrition rate of focused funds is higher than that of diversified funds.

Here is another tidbit I dug up from my files

The June 1998 issue of Money also provided us with evidence that the “overdiversification” excuse doesn’t hold water. Money, with assistance from Chicago consulting firm Performance Analytics, reviewed the performance of 22 private account managers whose performance placed them in the top 20 percent of their peer group. Each firm provided their single best idea. For the period beginning in May 1996 and ending in mid-June 1998, the average return of the 22 best picks was 53.5 percent, or a negative value added of 13.2 percent when compared to the return of 66.7 percent for the Wilshire 5000.

Hope that is helpful

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Post by Wagnerjb » Wed May 18, 2011 8:09 am

RPS wrote:We are essentially hard-wired to confirmation bias and, when strongly held beliefs are involved, being anything like "objective" is nearly impossible -- for all of us. But I know that and, as a consequence, try to check and test my strongly held beliefs and commitments all the time. I frequently change my mind. I don't come here for the echo chamber. I come here to try out and test ideas. I try to do that in a fair and respectful way. Why do you seem to suggest that there's something wrong with that?
RPS - this has nothing to do with "beliefs". It is all about data and statistics. Time and time and time and time again the studies have shown no way to identify the future mutual fund winners with any predictive probability over 50%. Math and statistics show the odds are not in your favor if you choose to invest in active management, and the odds get lower as the management costs get higher. Some people are willing to pay for the excitement (the "potential" to outperform), but most of us are very comfortable knowing that we will be in the top 80-90% of investors over a reasonable time period. (And that the top 5% will have achieved those results through luck, with a lot more losers left for dead along the way).

It is all about probabilities and math, based on an awful lot of studies.

Best wishes.
Andy

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Post by Moshito » Wed May 18, 2011 8:51 am

Call_Me_Op wrote:Put 1000 monkeys to work picking stocks. After 10 years, a subset of monkeys will have persistently outperformed the indexes. Need more be said?
What evidence do you propose to put forward to establish that Warren Buffett, Seth Klarman, Joel Greenblatt and the like are investment monkeys rather than highly skilled practitioners?[/quote]

I think the burden of proof is on those "highly skilled" practitioners to provide significant warrant to this fact that their skills are the reason for success. Looking at the other side, that they are in fact outliers of society, their luck and random stock picking. What you have stated does not disprove Call_Me_Op's post; there will always be those who outperform out of the enormous sample size of participants in the picking stocks.

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Post by RPS » Wed May 18, 2011 8:55 am

Wagnerjb wrote:[T]his has nothing to do with "beliefs". It is all about data and statistics.
Nonsense. Our prior commitments, beliefs and ideas all greatly influence how we interpret the data. That's why we are all so prone to accuse those who disagree with us of confirmation bias while missing it in ourselves.

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Post by RPS » Wed May 18, 2011 8:58 am

Moshito wrote:I think the burden of proof is on those "highly skilled" practitioners to provide significant warrant to this fact that their skills are the reason for success. Looking at the other side, that they are in fact outliers of society, their luck and random stock picking. What you have stated does not disprove Call_Me_Op's post; there will always be those who outperform out of the enormous sample size of participants in the picking stocks.
I think what they have said, written and done over many years makes that case. You're welcome to think that Buffett et als. are simply lucky monkeys. I disagree.

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Re: A Case for Active Management

Post by steve roy » Wed May 18, 2011 9:16 am

RPS wrote:
Rick Ferri wrote:Over a 20 year period, the probability that a portfolio of actively managed fund will outperform a comparable portfolio of index funds is less than 3%, and then it's not by much.

So, what exactly is the goal of trying to pick managers who are trying to beat the market? It seems like a large waste of time and money.
The universe of actively managed funds as described by the article (small and concentrated) is so much smaller than the universe of funds that are commonly thought of as active as to make your claim effectively irrelevant. Indeed, the article postulates that large funds with significant diversification, even though allegedly active, won't out-perform.
See, here's your problem. Assuming the article is correct, that "small concentrated funds with great active managers" outperform over time, how the hell do you expect a small, SUCCESSFUL concentrated portfolio to outperform for long stretches?

As soon as investors realize it's successful, they'll pile on. And as soon as they pile on, the fund balloons, can no longer remain "concentrated", and takes on the attributes of an index fund. (Of course, the managers could close the fund, but then you couldn't get into it, so what use is the success to newbies?)

The way I see it, this gent's theory may or may not be fine (I tend to think NOT), but in any event doesn't work in the actual, real world.

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Post by HomerJ » Wed May 18, 2011 9:25 am

RPS wrote:You're welcome to think that Buffett et als. are simply lucky monkeys. I disagree.
It doesn't matter if we agree or disagree...

Even if there are people out there who really have the skill, you and I will not be able to make any money off them...

You can easily look back and find 50 small concentrated fund managers with incredible 10-year returns, but only 3 of them will have another incredible 10 years going forward. Those three may actually be skilled, not just lucky monkeys, but the odds of you picking them are extremely slim.

Most funds who do beat the indexes are small and concentrated... As they gain a reputation, money flows in... When they were a $50 million dollar fund, betting $10 million on one small company could really juice their returns... Once they have $2 billion dollars under management, those $10 million dollar bets barely move their returns at all.

And it's not like they can just up their bets to $200 million... Those small companies don't have that many outstanding shares... Instead, they have to invest in the bigger companies, like Intel and Coke and Microsoft, same as all the other large mutual funds...

And they revert to the mean.

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Post by Rodc » Wed May 18, 2011 9:37 am

RPS wrote:
Moshito wrote:I think the burden of proof is on those "highly skilled" practitioners to provide significant warrant to this fact that their skills are the reason for success. Looking at the other side, that they are in fact outliers of society, their luck and random stock picking. What you have stated does not disprove Call_Me_Op's post; there will always be those who outperform out of the enormous sample size of participants in the picking stocks.
I think what they have said, written and done over many years makes that case. You're welcome to think that Buffett et als. are simply lucky monkeys. I disagree.
Unfortunately one simply can't collect a long enough set of data to prove skill - it may or may not be there, but data won't do the trick to prove one way or the other for one particular manager. Add to that as the size of a fund gets larger the game the manager is playing changes so skill is something of a moving target.

That said, I find it hard to believe markets are 100% efficient. I find it hard to believe that out of 10s of thousand of money managers none have skill. To me that makes no sense.

The trick is how do you find such a manager before they become well known and well established, and thus before they either close their fund to new investors or asset bloat greatly reduces their ability to really concentrate on their best ideas?

This is so hard that trying to pick a manager (or set of managers) who will significantly outperform an index fund asset allocation based portfolio makes no sense to me personally. It may not be as hard as picking a winning lottery ticket, but may be as hard as winning a small raffle. I might occasionally buy a raffle ticket for a good cause, but I don't really like the odds. (I have less concern with well diversified, low cost, low turnover active funds, but I think the farther you go down that road the closer you tend to get to having a closet index based portfolio, so why bother).
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Post by Doc » Wed May 18, 2011 9:56 am

rrosenkoetter wrote:
You can easily look back and find 50 small concentrated fund managers with incredible 10-year returns, but only 3 of them will have another incredible 10 years going forward.
At the risk of having my quick and dirty screens criticized again:

(Fund Category = Small Blend)
and (Distinct Portfolio Only = Yes)
and (Fund Size (Total Assets in $MM) <= 63)


The addition of the fund assets under management criteria is

Median Three Year Return all sizes ~4.8%
Lowest quartile AUM Three Year Return ~2.7%

Caveat: I have no idea what to do with these results other than to opine that assets under management may not be a good indicator of performance.

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Re: rps

Post by matt » Wed May 18, 2011 10:20 am

larryswedroe wrote:The June 1998 issue of Money also provided us with evidence that the “overdiversification” excuse doesn’t hold water. Money, with assistance from Chicago consulting firm Performance Analytics, reviewed the performance of 22 private account managers whose performance placed them in the top 20 percent of their peer group. Each firm provided their single best idea. For the period beginning in May 1996 and ending in mid-June 1998, the average return of the 22 best picks was 53.5 percent, or a negative value added of 13.2 percent when compared to the return of 66.7 percent for the Wilshire 5000.
In a separate thread, you wrote: "First, the STANDARD for measuring alpha is the three factor (or four) model, not volatility--the one factor model is long gone."

Yet above, you are using the one factor model to claim that those managers underperformed. Based on your own statements, the Money analysis is not useful in making this determination.

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Post by RPS » Wed May 18, 2011 10:26 am

Rodc wrote:Unfortunately one simply can't collect a long enough set of data to prove skill - it may or may not be there, but data won't do the trick to prove one way or the other for one particular manager.
I agree. That's another reason I'm skeptical of the so-called "4% rule" in general, for example.
Rodc wrote:Add to that as the size of a fund gets larger the game the manager is playing changes so skill is something of a moving target.
I agree.
Rodc wrote:That said, I find it hard to believe markets are 100% efficient. I find it hard to believe that out of 10s of thousand of money managers none have skill. To me that makes no sense.
Again, we agree.
Rodc wrote:The trick is how do you find such a manager before they become well known and well established, and thus before they either close their fund to new investors or asset bloat greatly reduces their ability to really concentrate on their best ideas?
Exactly. I suspect that a few really great managers can accomplish this trick even with size, but for those who are only very good, size matters. My working hypothesis is that outperformance is likely to persist with managers who are small, concentrated and have a strong, quantitative value bias. I recognize that my working hypothesis could be dead wrong.
Rodc wrote:This is so hard that trying to pick a manager (or set of managers) who will significantly outperform an index fund asset allocation based portfolio makes no sense to me personally. It may not be as hard as picking a winning lottery ticket, but may be as hard as winning a small raffle. I might occasionally buy a raffle ticket for a good cause, but I don't really like the odds.
But, as behavioral finance points out, we like to play and we like to win, even if and when it may not make sense.
Rodc wrote:(I have less concern with well diversified, low cost, low turnover active funds, but I think the farther you go down that road the closer you tend to get to having a closet index based portfolio, so why bother).
If it's truly well-diversified, it may as well be an index fund (though I prefer equal-weighted, fundamentally-weighted or value-weighted indexes -- recognizing that some will see these as active management in disguise -- to cap-weighted indexes, since I see these as necessarily being prone to bubble risk).

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Post by pkcrafter » Wed May 18, 2011 11:17 am

RPS wrote:
You both have raised the key point. I am extremely confident that an equally-weighted index will out-perform a cap-weighted index over the long haul because a cap-weighted index will -- of necessity -- be prone to bubble risk. I am highly confident (but less so) that a fundamentally-weighted index will do even better for the same reason (and more so). Properly constructed (huge caveat, I know), a value weighted index should do better still, but my level of confidence is decidedly less strong since, as Keynes famously put it, the market can be irrational longer than one can remain solvent (late 90s anyone?). A small and concentrated portfolio has the best possibility for the highest returns, but the margin for error is quite high and our ability to identify the right manager(s) is highly questionable.
I can agree with much of what you say, and confirmation bias causes investors to seek opinions that agree with what they already believe. You won't get too much confirmation here, but it's good that you seek opinions that don't always agree with yours. At least if gives you something else to consider. If you cannot put up a good defensive argument, then you better reconsider your position.

I think that some investors who use active funds can beat the indexes, but it gets harder and harder as time goes on. And it must take some luck to do it because an investor cannot constantly choose the right manager in advance, and this is what they must do. Furthermore, the right concentrated funds must be distinguished from concentrated sector funds and timing funds, both of which do not outperform according to the studies. Concentrated funds are very sensitive to cash inflows, which is bound to occur with good numbers. And they will all experience alpha fade and the fade rate and subsequent performance will be unknown. If an investor holds five such funds, it's highly likely one will fail and need to be replaced each year. The luck factor is where active investing loses its appeal.
The universe of actively managed funds as described by the article (small and concentrated) is so much smaller than the universe of funds that are commonly thought of as active as to make your claim effectively irrelevant.

Yes, the field is much smaller, but all knowledgeable active investors will be seeking these funds.
A small and concentrated portfolio has the best possibility for the highest returns, but the margin for error is quite high and our ability to identify the right manager(s) is highly questionable.
Well, there you go. :)

Code: Select all

Nonsense. Our prior commitments, beliefs and ideas all greatly influence how we interpret the data. 
Good point and easily worthy of it's own discussion. I have been trying to understand why some investors will choose active investments and some choose passive, and I think this is part of the puzzle. Certainly, active management would seem to fit the ideas we grow up with, whereas indexing is not intuitive at all.

As for equal-weighting, I see nothing of interest. Fundmental indexing and value may outperform some of the time, but not all of the time.
You both have raised the key point. I am extremely confident that an equally-weighted index will out-perform a cap-weighted index over the long haul because a cap-weighted index will -- of necessity -- be prone to bubble risk.
I will worry about this the next time we have a market like 1999.


Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

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Post by RPS » Wed May 18, 2011 11:56 am

pkcrafter wrote:I can agree with much of what you say, and confirmation bias causes investors to seek opinions that agree with what they already believe. You won't get too much confirmation here, but it's good that you seek opinions that don't always agree with yours. At least if gives you something else to consider. If you cannot put up a good defensive argument, then you better reconsider your position.
Of course, what we see as good defensive arguments is influenced by what we already think....
pkcrafter wrote:I think that some investors who use active funds can beat the indexes, but it gets harder and harder as time goes on. And it must take some luck to do it because an investor cannot constantly choose the right manager in advance, and this is what they must do.

I agree.
pkcrafter wrote:Furthermore, the right concentrated funds must be distinguished from concentrated sector funds and timing funds, both of which do not outperform according to the studies.

I agree re timing, but think that a value bias provides alpha over time (if not at all times). F&F recognize that a value bias works, but try to explain it away due to some alleged risk factor. Confirmation bias?
pkcrafter wrote:Concentrated funds are very sensitive to cash inflows, which is bound to occur with good numbers. And they will all experience alpha fade and the fade rate and subsequent performance will be unknown.
That's a real risk.
pkcrafter wrote:Yes, the field is much smaller, but all knowledgeable active investors will be seeking these funds.

Since it's only "knowledgeable active investors," we've got a shot....
pkcrafter wrote:I have been trying to understand why some investors will choose active investments and some choose passive, and I think this is part of the puzzle. Certainly, active management would seem to fit the ideas we grow up with, whereas indexing is not intuitive at all.
As I noted above, we all tend to like to play and to win. Meir Statman has some good research on this.
pkcrafter wrote:As for equal-weighting, I see nothing of interest. Fundmental indexing and value may outperform some of the time, but not all of the time.
Cap-weighting requires that we keep (in effect) buying over-priced stocks the more over-priced they get. These efforts to avoid that (along with re-balancing) give us an interesting opportunity to out-perform, I think.
pkcrafter wrote:I will worry about this the next time we have a market like 1999.
With P/E10 around 24, it's not 1999, but things aren't promising either. Moreover, due to low yields, bonds can't provide much protection. There is good reason to be very concerned.

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Post by HomerJ » Wed May 18, 2011 12:41 pm

Okay, you agree that it's impossible to pick the few winning managers ahead of time.

So what exactly is your "Case for Active Management"?

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Re: A Case for Active Management

Post by norookie » Wed May 18, 2011 12:51 pm

Rick Ferri wrote:
"There’s compelling evidence, moreover, that a subset of active managers do persistently outperform indexes."
No one is denying this. Over any period there will be active managers who beat their benchmark. The challenge is knowing which managers will do it in the future. That's were analysis consistently fails.

Then, of course, you have the added challenge of picking active managers across multiple asset classes. Here we find that active manager risk is cumulative, not dilutive. The more active mangers you add to a portfolio, the lower the probability the portfolio will outperform a comparable portfolio of index funds.

Over a 20 year period, the probability that a portfolio of actively managed fund will outperform a comparable portfolio of index funds is less than 3%, and then it's not by much.

So, what exactly is the goal of trying to pick managers who are trying to beat the market? It seems like a large waste of time and money.

Rick Ferri
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Post by larryswedroe » Wed May 18, 2011 12:54 pm

You have got to be kidding.
If you have a single best idea and no constraints then clearly you are not adding value relative to the market.

Now if the manager beat the market with a single idea that would not be adding alpha necessarily, because they might have taken more risk. so would have to benchmark against proper index, or 3 factor regression for a portfolio.

BTW-the value premium was large during the period about 8% per annum, while the small premium was negative, about -9%. So clearly if they were buying large, growth or value stocks they still underperformed even a risk adjusted benchmark. Only if they ONLY bought small caps would they possibly produced alpha relative to the benchmark

But remember, they took more risk than market and got less returns with their single best ideas, unconstrained. Clearly the evidence here (though one small sample) is concentration doesn't help.

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Post by RPS » Wed May 18, 2011 1:12 pm

rrosenkoetter wrote:Okay, you agree that it's impossible to pick the few winning managers ahead of time.
Difficult is not impossible. I grant difficult, but not impossible (at least not yet).

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Re: A Case for Active Management

Post by dratkinson » Wed May 18, 2011 1:24 pm

Doc wrote:...
It is no problem to come us with a subset of active managers who beat the index. It is somewhat harder to come up with the subset who will beat the index in the future but dratkinson didn't think through the question enough to ask the right question. :) And the "right question" can't be answered for another ten years. On the other hand if you want to talk about the probabilty of picking that future outperformer based on the best information we have you can get an answer. Whether the resulting probability is high enough to make up for the effect of the false postive is again another matter.
Well... actually I did think of the correct question, but I'd already logged off and didn't get back to this until now.

Should have asked:

Name 'em... and how long their out-performance (of the market) will persist, and by how much?

(added) I said I was slow. :)
Last edited by dratkinson on Wed May 18, 2011 1:34 pm, edited 1 time in total.

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Post by HomerJ » Wed May 18, 2011 1:30 pm

RPS wrote:
rrosenkoetter wrote:Okay, you agree that it's impossible to pick the few winning managers ahead of time.
Difficult is not impossible. I grant difficult, but not impossible (at least not yet).
Okay name one who's going to beat their appropriate index over the next 15 years...

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Re: Matt

Post by matt » Wed May 18, 2011 1:38 pm

larryswedroe wrote:You have got to be kidding.
If you have a single best idea and no constraints then clearly you are not adding value relative to the market.

Now if the manager beat the market with a single idea that would not be adding alpha necessarily, because they might have taken more risk. so would have to benchmark against proper index, or 3 factor regression for a portfolio.

BTW-the value premium was large during the period about 8% per annum, while the small premium was negative, about -9%. So clearly if they were buying large, growth or value stocks they still underperformed even a risk adjusted benchmark. Only if they ONLY bought small caps would they possibly produced alpha relative to the benchmark

But remember, they took more risk than market and got less returns with their single best ideas, unconstrained. Clearly the evidence here (though one small sample) is concentration doesn't help.
Nope. Not kidding. I have no idea who these managers were or over what time frame their performance was chosen to determine that they were "stars". I don't know what type of stocks they picked.

What I do know is that from May 1996-June 1998, the Russell 1000 outperformed the Russell 2000 by 26% and MSCI EAFE by 54%. So there were clearly huge deviations in sub-asset class performance that could have been the cause of the underperformance of the "stars". In other words, the Money article has the same potential error in benchmarking that you routinely criticize.

You can't have it both ways. I'm not claiming that these "stars" were worth a damn and I don't really care (I think the concept of the test is dumb to start with), but if you say a multi-factor model is needed for benchmarking, then you need to use it all the time, not selectively. If you can list all of the stocks picks in the contest here and they were overwhelmingly large cap names in 1996, then your case is made. But if it's full of small caps and foreign stocks, then my case is made.

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Post by Random Musings » Wed May 18, 2011 1:42 pm

Difficult is not impossible.
Difficult is another way of saying to look through that damn rear view mirror one more time.

When we finally get to that fork in the road where a few will thump their chests with pride (there always will be some), could we at the very least, use a risk adjusted rear view mirror? That eliminates a good portion of our headaches.

Then we get to the "is it statisically significant, or are they just kidding ourselves" analysis. At that point, there are typically about a few handful (or less) of active funds left.

At this point of time, a bunch of active proponents will post (after the fact, of course) that they have owned these funds for that entire duration - like when the fund had about $2MM in AUM :roll: ).

Then, rinse and repeat. Deja vu, all over again.

Let's pretend we are a casino. Could we please place our bets before the cards are dealt? That's just like the real world of investing.

RM

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