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by Ron Surz
on March 17, 2016

Tags: FinTech

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:

  1. Based on Dr. William F. Sharpe's "Arithmetic of Active Management", 50% of active managers should beat their benchmark. The fact is only 20% beat their benchmark, far below expectations.
  2. 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.
  3. 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.
  4. 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.

Ronald J. Surz is a partner and CIO of Paladin Financial Technology. He is also president of PPCA Inc.and Target Date Solutions and a partner of TDF Builder, and Sortino Investment Analytics.