Dear Editor,

While I have seen Dr. Howard and his business partner, Dr. Craig Callahan of ICON Funds, present their studies and have great respect for their work, I see one critical error in the methodology presented in this letter.  By measuring the alpha of a fund versus the S&P 500, he is using extremely biased benchmarking.  Could it be that midcap funds, emerging market funds, small value funds and international funds mostly have higher alphas than the S&P 500 simply due to the fact that these asset classes have outperformed the S&P 500 from 1980 - 6/2008?

In other words, there may be some managers in the small value space that have severely underperformed the small value index, but by their nature of being small value funds, have still beaten the S&P 500.  This is alpha generated by asset class, not manager skill.  As another example, even the lower quartile emerging markets managers have likely beaten the S&P 500 since 2002, but they are certainly not adding alpha versus an emerging markets benchmark.  The "alpha" that Dr. Howard seems to be measuring largely depends on the field in which the manager is playing, not the skill with which he is playing the game.

Regards,

Kane S. Cotton
Sr. Portfolio Strategist
Capital Allocation & Management, Inc.

Dear Editor,

I want to offer some feedback to the Editor and to Dr. Howard regarding Dr. Howard's letter to the Editor on the "Luck vs. Skill" research by Dr. Wermers, et. al.

Wermers’ research and discussion may well not have been complete.  But the review submitted to the Editor was also far from comprehensive and failed to address a few important matters (implied assumptions) associated with the assertions it made.

I'm not sure that the matter of the dropping funds having a history shorter than 60 months was given sufficient attention in the letter.  Howard asserts that "superior" manager performance is more pronounced in the basket of managers having less than 60 months of run time than for those having 60+ months in operation.  But is that performance really superior?  If so, superior to what? Generic benchmarks that bear little or no resemblance to the strategies at play? 

Speaking entirely anecdotally but, I think, quite correctly, don't new fund launches tend to be made covering those parts of the economy (i.e., sectors and sub-sectors) that have already experienced at least a short period of favorable performance and which, generally or on average, have a bit of sector-specific mileage left in them?  Is that really alpha? Or, rather, is that sector or sub-sector-specific beta? 

The assumption that the benchmarks are appropriate ought to be nailed down head-on in any research significantly impacted by it (including Wermers’ as well as Howard's response).  I have serious doubts about manager performance relative to appropriate benchmarks.  Based on the totality of research that I've reviewed, I could reasonably and (I believe) convincingly argue that the Three Stooges could have done as well as most managers against broad, generic (and irrelevant) benchmarks.  The onus is and should be on the manager side of the table - and "benchmarking" assumptions need to be fully raked over.

Clearly, I don't trust the "benchmarking" gig that the mutual fund industry uses and that most researchers fail to properly address --- in which case resulting analysis is fundamentally flawed from the start.  Lack of clarity on the part of the mutual fund industry in this area is irresponsible.  Lack of clarity on the matter in the research domain is simply bad science.

Wouldn't it be extremely, extremely naïve to expect newer funds, on average, to do anything other than to perform "better" relative to broad, generic index "benchmarks" than those that are still hanging around after their area-specific (not necessarily benchmark) cyclical performance pendulum has swung away and the manager’s Midas touch (surprise, surprise) just doesn’t seem to work like it once did (maybe 60 months earlier)?  Come on.

And to a substantial portion of the apparently vast pool of "skilled" fund managers, of which nearly any manager can claim to be a part (depending on what liberties are taken with the modeling and interpretive brush): a spade is a spade is a spade.

Advisor Perspectives has had some great (i.e., truly useful) reports over the last couple of months.

Best Regards,

The author of this letter asked to remain anonymous.

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