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Making The Patient Sicker

By Craig Lazzara Years ago, I saw a cartoon picturing two Victorian-era doctors discussing a patient. “What did you prescribe for Jones’ rheumatism?” asked the first; the second answered “A cold bath and a brisk walk every morning.” “Good God, man, that will give him pneumonia!” said the first. “I know,” replied the second doctor, “I made my reputation curing that.” Somehow I was reminded of this exchange when I learned from this morning’s news that some institutional investors, smarting from recent losses, are considering increasing their commitment to active equity management. Their operating assumption seems to be that active managers will do a better job of capital preservation in a challenging and volatile market. There’s certainly some plausibility to this argument. It turns out, however, to be another beautiful theory mugged by a gang of facts . The facts come from our periodic SPIVA reports, which compare the results of actively-managed mutual funds against passive benchmarks. Weak markets, it turns out, are no panacea for active managers. In 2008, e.g., 54% of large-cap U.S. funds underperformed the S&P 500. Results were even worse for mid- and small-cap managers (75% and 84% underperformers, respectively). Statistics say, in other words, that moving from passive to active as a way of managing market volatility is likely to make performance worse, not better . Fortunately for anxious investors, passive strategies which focus on the lowest volatility segment of the equity market are most likely to outperform precisely when the market is weakest. Consider, for example, the S&P 500 Low Volatility Index and its cousin, the S&P 500 Low Volatility High Dividend Index: Both of these indices are designed to attenuate the returns of the S&P 500 in both directions; historically, they have both tended to underperform market rallies but outperform when markets are weak. Their reliability as defensive vehicles has far exceeded that of active management. Investors concerned about continuing volatility and market weakness should consider indicizing their defensive strategies. Disclosure: © S&P Dow Jones Indices LLC 2015. Indexology® is a trademark of S&P Dow Jones Indices LLC (SPDJI). S&P® is a trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a trademark of Dow Jones Trademark Holdings LLC, and those marks have been licensed to S&P DJI. This material is reproduced with the prior written consent of S&P DJI. For more information on S&P DJI and to see our full disclaimer, visit www.spdji.com/terms-of-use .

The New Definition Of Investment Manager Success: How To Tell Who’s Winning

It’s become self-evident recently that peer groups suffer from “loser bias” because the majority of active managers underperform their benchmark. Beating the losers is not a “win.” Peer group comparisons simply don’t work anymore. Beating the benchmark is a good beginning, especially when combined with a statistical test of significance called a “Success Score.”. If intermediaries continue to use peer groups, as is likely the case, investors will continue to be disappointed because they’ll continue to hire losers. In the “good old days,” investment managers had two shots at winning. They could beat their index or they could beat the median manager in their peer group. That peer group thing doesn’t work anymore. Due to the popularity of passive ETFs and the emergence of Robo Advisors, there is only one pertinent yardstick – beating the benchmark. Unfortunately , less than 20% of active managers achieve this measure of success. This active manager failure renders peer groups worse than useless. It is now well-understood that peer groups suffer from “loser bias,” in addition to survivor and classification biases. Loser bias is the reality that more than 80% of the managers in a peer group are losers since they fail to beat their benchmarks. Beating the losers is like winning the prize for best ballerina in Waco. Investors need to demand better. So the new definition of “success” is beating the benchmark, but there’s more to winning than this simple measure. We want to know that success is not just luck, that it is likely to repeat in the future. That’s where statistics and “Success Scores” come in. We call it a “win” if the outperformance of the benchmark is statistically significant. Success Scores are the statistical significance of benchmark outperformance. A facsimile of a peer groups is created by forming all the portfolios that could be formed from the stocks in the index. A ranking against these Success Scores in the top decile is significant at the 90% confidence level – we can be 90% sure that it wasn’t just luck. Success Scores are bias free and available a day or two after quarter end. It’s not enough to beat the benchmark. An investment manager needs to beat his benchmark by a significant amount to be a true winner. Success Scores are especially worthwhile for hedge fund managers since peer groups of hedge funds are just plain silly. The tradition of disappointment in active managers will continue if clients (investors) allow it to continue. Clients deserve better,but they need to know how to get it. Investors need to understand their advisor’s due diligence process and to be concerned if it includes peer group comparisons. In other words, investors should seek out advisors who employee contemporary due diligence tools if they are relying on their advisor to select good investment managers. Here are some facts every investor should know: Based on Dr. William F. Sharpe’s “Arithmetic of Active Management”, 50% of active managres should beat their benchmark. The fact is only 20% beat their benchmark, far below expectations. The search for “alpha” uses regression analysis. “Alpha” is the Greek letter for the intercept. It is well-documented that it takes at least 50 years for a manager with “average” skill to deliver a statistically significant alpha. By contrast, “Success Scores” can provide significance for very short periods, like one year. 70% of managers are active, not passive. Towers Watson, a prestigious investment consulting firm, says this number should be closer to 30%. There are too many active managers. Approximately 40% of funds in a peer group don’t belong because they’re different. This problem is called Classification bias. For hedge fund peer groups, most funds don’t belong because hedge funds are unique, which by definition means without peers. Knowledge is power. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Nothing New About Gold

By Roger Nusbaum, AdvisorShares ETF Strategist A big part of successfully engaging in markets (success defined as not doing yourself in with poor decision making and having enough money when you need it) is revisiting certain principles that although crucial can be forgotten when they are most important. A great example of this is holding onto a small allocation to gold for its low to negative correlation to equities. I’ve written about this regularly for more than ten years with the main points being that gold continues to not look like the stock market. That was true ten years ago when equities were flattish and gold went up, it was true during the worst of the financial crisis when stocks went down a lot and gold was kind of flattish, it was true in the most recent bull market when equities rocketed and gold sunk. It is playing out as true now as equities have rolled over for the last six months while gold and mining stocks too for that matter have gone up. Play around with some ticker symbols on Google Finance and you’ll see that the S&P 500 is down high single digits for the last six months while ETFs tracking gold are up about 10% and ETFs tracking miners are up in the neighborhood of 30%. While I don’t think too many investors will want to take on the volatility that goes with the miners, the point is still the same. I continue to believe that if gold is the top performing holding you have then chances are things are going so well in the world and that seems to fit right now. Questioning gold’s role as a portfolio holding gained momentum in the media and blogs as equities continued to rally which is in part about impatience which to the intro of this post is one behavior that does investors in. This ties into a slightly bigger concept or investing belief about defense being more important than offense or as I’ve described it; smoothing out the ride. Using gold to help with that objective can be done without having to be very tactical with it; you own it and without having to figure out when equities might turn down, you have the position in place for whenever they do. Clearly this does not resonate with everyone; if it does not resonate with you then you probably don’t own any gold and if it does resonate with you, then you do have some gold but the time to make this decision is not now when volatility is sky high and emotions/indecision might also be elevated. Bigger picture still, is the importance of remembering why you chose whatever you chose for your approach to investing and knowing what type of market environments play to your approach’s strengths and weaknesses. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: To the extent that this content includes references to securities, those references do not constitute an offer or solicitation to buy, sell or hold such security. AdvisorShares is a sponsor of actively managed exchange-traded funds (ETFs) and holds positions in all of its ETFs. This document should not be considered investment advice and the information contain within should not be relied upon in assessing whether or not to invest in any products mentioned. Investment in securities carries a high degree of risk which may result in investors losing all of their invested capital. Please keep in mind that a company’s past financial performance, including the performance of its share price, does not guarantee future results. To learn more about the risks with actively managed ETFs visit our website AdvisorShares.com .