Tag Archives: time

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.

How Long Will You Wait For Smart Beta To Work?

In my last post I shared some insights from Ben Carlson’s A Wealth of Common Sense , which argues that investors are generally better off keeping their portfolios simple and straightforward. This idea has little appeal for index investors who hope to improve on plain-vanilla funds by using so-called smart beta strategies. “Smart beta” refers to any rules-based strategy that attempts to outperform traditional cap-weighted index funds. Now more than a decade old, fundamental indexing is the granddaddy of smart beta, while factor-based strategies are the newer kids on the block. In each case, the goal is to build a diversified fund that gives more weight to stocks with certain characteristics (value, small-cap, momentum, and so on) that have delivered higher returns than the broad market over the long term. Many proponents of passive investing see huge potential in factor-based strategies because they combine the best features of indexing-low-cost, broad diversification, and a rules-based process-with the potential to overcome the shortcomings of traditional cap-weighting. Indeed, many of our clients at PWL Capital use a combination of traditional ETFs and equity funds from Dimensional Fund Advisors (DFA) , which have greater exposure to the small-cap, value and profitability factors . The academic research on factor-based investing is robust and convincing, and building your portfolio using these principles may be rewarding over the long term. Ben Carlson thinks so, too, despite the emphasis he puts on simplicity. But he has some cautionary words for those who are ready to jump on the smart beta bandwagon. “I think these strategies can make sense as part of a broadly diversified portfolio if you know what you’re getting yourself into,” he writes. A costlier, bumpier ride Let’s start with the most obvious caveat: smart beta is cheap compared with active strategies, but it’s significantly more costly then traditional ETFs. Cap-weighted ETFs carry almost negligible costs these days, with fees as low as 0.05%, while factor-based funds tend to have MERs in the range of 0.40% to 0.80%. That means they need to deliver significant outperformance before fees to simply break even on an after-cost basis. Second, any outperformance is probably going to involve a rockier ride. While it’s not true over every period, small-cap and value stocks are typically more volatile than the broad market, so their excess returns may require you to endure more swings in your portfolio. Over the last five years, for example, that standard deviation (a measure of volatility) for both value and small cap stocks was higher than that of the broad market in Canada, the U.S. and international markets. And as Carlson notes: “One of my common sense rules of thumb states that as the expected returns and volatility of an investment increase, so too does poor behavior.” Which brings us to the biggest challenge for investors who use smart beta strategies. The waiting is the hardest part Investors who embrace smart strategies are usually familiar with the research showing that small-cap and value stocks have outperformed over the very long term in almost every region. But few appreciate that to those premiums can take a long time to show up-and were not talking about a mere five or 10 years. In his book, Carlson explains that from 1930 to 2013, small-cap value stocks in the US delivered an annualized return of 14.4%, compared with 9.7% for large caps. However, small-cap value lagged the S&P 500 for a 15-year stretch in the 1950s and 1960s, then for seven more years from 1969 to 1976, and finally for a gruelling string of 18 years in the 1980s and 1990s. “Eventually they paid off, but that’s a long time for investors to wait. Patience is a prerequisite for these strategies.” That’s an understatement. It’s not uncommon for investors to lose faith in a strategy after a year or two. It’s hard to imagine many will hang on to an underperforming smart beta fund as it lags the market for even five years-let alone 18-because they’re confident it will outperform over a lifetime. Almost no one has that kind of patience-with the possible exception of Leafs fans . “You have to commit to these types of strategies, not use them when they feel comfortable,” Carlson says. “The reason certain strategies work over the long term is because sometimes they don’t work over the short to intermediate term.” Tracking error regret Just this week, Larry Swedroe expanded on this idea by looking at the probability that the small and value premiums will be negative over various periods. He demonstrates that there’s a significant chance of underperformance over even a decade or two. “My almost 20 years of experience as a financial advisor has taught me that even the most disciplined investors can have their patience sorely tested by as little as even a few years of underperformance,” he confirms, “let alone a 10-year period without higher returns for value (or small, or international, or emerging market) stocks.” Swedroe goes on to coin a brilliant term for the anxiety indexers feel when their smart beta strategies go awry: tracking error regret . “These are investors who regret their decision to maintain a portfolio that performs differently than the market. Tracking error regret causes many investors to abandon their well-thought-out, long-term plans.” The point here is not that you should ignore alternatives to portfolios built from traditional index funds. Smart beta strategies may indeed reward the patient, disciplined investor over the very long term. But no investors should ever feel they’re settling for second-best with a simple solution. In the end, these traditionalists will likely find it easier to stay on course, and may just end up looking like the smart ones.