Description: Investment Risk Management, Skill Evaluation, and Predictive Performance Analytics
A recent MarketWatch piece cited a talk in Hong Kong by Economics Nobel Prize winner Professor Robert Merton wherein he discussed the challenges of evaluating investment managers. The following article assumes that the above summary of Professor Merton’s talk is accurate. The piece, and assumedly the talk, argued that, given typical nominal portfolio returns and volatilities, it takes impractically long to detect evidence of investment skill. The argument claimed to prove that all manager selection is futi
Any test of the effectiveness of manager selection is also a test of the analytical process that distills skill. That nominal investment performance is primarily due to factor (systematic, market) noise and thus reverts is well-known. It is thus unsurprising to find flaws in an approach to manager selection that is as antiquated as Ptolemaic Astronomy .
In this article, we will illustrate the difference between a naïve attempt to detect evidence of investment skill using nominal returns and a more productive effort relying on alphas ( residual , security selection, stock picking returns) isolated using a capable modern multi- factor equity risk model. Whereas the former approach is futile at best, the latter approach is successful. In fact, rather than taking decades, a capable modern system can identify skill with high confidence in months.