Ron Surz of PPCA Inc. says he’s built a better mousetrap of indices used for benchmarking and analyzing money managers. In fact, he’s just following the advice of a Nobel Laureate.
Professor William Sharpe, who shared a Nobel Prize in 1990 for his work on developing the Capital Asset Pricing Model, laid out the foundation for returns-based style analysis in a 1992 paper. The strategy is one of analyzing, say, a mutual fund’s returns by regressing performance against various indexes to determine what’s driving the performance. In essence, it’s a quick and fairly reliable way of x-raying a portfolio to see what’s going on behind the scenes.
For example, by running a returns-based style analysis on an actively managed large-cap U.S. stock fund, one might learn that the benchmark-beating results came primarily from loading up in small-cap companies. There’s nothing wrong with that, of course. But if you’re telling the world that your benchmark is large-cap stocks, you’ll have some confused (or angry) investors if they learn that you’re buying small-cap equities. Perhaps, then, a small-cap index is the better benchmark for the fund, in which case maybe the large-cap manager’s performance doesn’t look so impressive after all.
So it goes in the world of analyzing managers. Trying to make apples-to-apples comparisons is the bane of analysts who are forever attempting to separate alpha’s wheat from beta’s chaff. No easy task in the best of times. Talent, after all, isn’t easily defined, and less-than-obvious when looking only at numbers. Indeed, surveying past performance offers no foolproof way for deciding that manager A has the right stuff and manager B is a pretender to the throne. That’s not to say that reviewing the past is worthless. But there are limits to studying history as a short-cut to seeing the future.
That said, some argue that an effective search for talent requires going through a portfolio’s holdings with a fine tooth comb, and comparing changes over time. But a holdings-based analysis isn’t practical because managers’ reports are infrequent, and quite often out of date. In the case of some hedge funds, you might not ever learn what it’s in the portfolio. So much for timely analysis.