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Bass Ackwards: The Fishy Tale of the Index
Huggers' Edge Investment Manager Selection
Criteria Have Gone Awry

Ron Surz
September 16, 2008

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Bulging Nets

Trolling for talent isn’t as easy as some think, unless the only catch you’re after is index huggers. Indexed nets fill with porpoises. No offense to index huggers. Some of my best friends love their indexes, and I’m glad they have an edge.

In the 1980s, there was significant interest in custom benchmarks, and a few firms sprung up to provide what were then called “normal portfolios”, which are custom collections of stocks with custom weights. The CFA Institute’s Benchmark Committee Report recommends the use of custom benchmarks over indexes and peer groups. The good news is that today we have a variety of tools, like style and factor analyses, that make it straightforward to construct custom benchmarks. Among other things, these tools give us a sense of how a manager differs from an off-the-shelf index to illustrate sources of performance differences.  The tools are there waiting for the thoughtful user.

Once the right benchmark is created, there are additional tools that can help us accurately evaluate investment performance.  My firm offers one such tool, Portfolio Opportunity Distributions (PODs). PODs expand any benchmark into a peer group, and as such they are benchmark agnostic, although of course they work best when the benchmark is correct. Pick your favorite benchmark and PODs provide a performance ranking against the opportunities available to those who manage to that benchmark.  For example, let’s say you are analyzing the performance of a fund against the S&P 500.  The problem with a strict comparison to the S&P 500 is that you will wait decades to gain statistical confidence in the manager’s ability to beat this benchmark because the hypothesis test “Performance is good” is being conducted across time. By contrast, PODs conduct this hypothesis test in the cross section of all possible returns, by simulating portfolios made up exclusively of stocks in the benchmark. The middle, or median, of these simulated returns is the S&P 500 return. A POD rank in the top ten percent of all possibilities is significant at the 90% confidence level even if it is for a short time period, like a few months.

The Beneficiaries

PODs are only one tool that liberates advisors from the biases imposed by portfolio construction based on style boxes.   Other tools, such as Dr. Sortino’s Omega Excess and Gary Anderson’s Benchmark Equivalence Line (BEL) can be used effectively to achieve this goal.  The ultimate beneficiaries of these improved tools are our clients. You’d think investment managers would also benefit, but  obfuscation is good in the very competitive investment game. Skilled sales and client relationship people thrive on benchmark subterfuge, presenting indexes and peer groups that make them look best. Dr. Meir Statman says this well:

“Today’s money managers say they compete with other money managers by generating the highest alphas. They denigrate the role of marketing in the competition. Yet each money manager has ready stories about other money managers with low alphas who snatched clients through clever marketing….I hope that in the future the link between investment and marketing would become stronger and more explicit.”

“What do Investors Want?” The Journal of Portfolio Management, 30th Anniversary Issue 2004, pp 153-161

 

Ron Surz is President of PPCA, Inc. and can be reached at

 

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