Y'all ready for this?
From Advisor Perspectives:
Mankind has landed a spacecraft on a comet 300 million miles away. Yet, after decades of academic research, the challenge of distinguishing skill from luck among actively managed mutual funds has remained largely unsolved.
Much is at stake in this challenge. If skill can be identified, then it is likely to persist, affording clients superior performance. But a manager who is merely lucky will eventually succumb to underperformance.
If rocket science has a counterpart in financial analysis, it is in the quantitative analytics from companies like Boston-based Northfield Information Services. Last week, I spoke with Dan di Bartolomeo, founder and CEO, to see if he could detect skill or luck among the two biggest fixed-income managers: Bill Gross, when he managed the PIMCO Total Return Fund (PTTRX), and Jeffrey Gundlach, manager of the DoubleLine Total Return Fund (DBLTX).
Northfield has been providing risk analysis and tools for portfolio construction to institutional asset managers for 30 years. Among its noteworthy accomplishments, Northfield’s analysis was used by Harry Markopolos to confirm that Bernie Madoff was engaged in a massive Ponzi scheme.
Scores of academicians and commercial vendors have attempted to identify skillful managers. The problem, di Bartolomeo said, is that most people “do this badly” and don’t deal with all the issues in sufficient detail.
Northfield’s methodology was originally published in this 2006 paper. Di Bartolomeo said the published results documented predictive power that was three times stronger than what was previously reported in the academic literature. It was both economically and statistically significant.
I’ll discuss the results of the Gross versus Gundlach analysis, but first let’s review Northfield’s system for distinguishing skill from luck.
A four-step process
Northfield’s methodology is based on the assumption that skill –once identified—will persist. If a manager’s performance is due to skill, that skill – or lack thereof – will continue. If a manager’s performance is due to luck, however, the best guess for future performance is the average of an appropriately constructed peer group. In other words, if a manager’s outperformance is due to luck, it will eventually revert to the mean.
According to di Bartolomeo, the academic literature has found that performance is persistent over a relatively short time horizon, “one to three years, depending on who you believe.” Northfield tested its results over a one-year time horizon.Previously on the pump up the music channel:
Each fund is analyzed using a four-step process. Northfield first determines the appropriate peer group for each fund. An iterative methodology with returns-based analysis is used, a tool first developed by William Sharpe. Di Bartolomeo described this as a “very numerically intensive” processes, which uses a large group of funds to find ones that act similarly. For every fund, Northfield determines a distinct and custom peer group.
“Unless you correctly classify funds, there is no persistence in fund performance,” di Bartolomeo said. “If you don’t, you might as well be throwing darts.”
The second step is to identify how much history should be used in that fund’s analysis. Northfield does this with a tool known as CUSUM. Developed in the 1950s, CUSUM is a sequential probability test that was first used to measure quality control on assembly lines. It looks for trends in the number of rejects. Bad performance for a mutual fund is like a reject on an assembly line....MORE
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