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Archive for April 22nd, 2009

The Ultimate Sin album cover
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A few years ago I found a document put out by DrKW Macro Research called “The Seven Sins of Fund Management” (caution – PDF) – it is truly an awesome piece of work, and a brilliant critique of the mutual fund space (and active managers in general).  I could not remember where I had found it – so I’m going to thank whoever originally posted it and then re-post it here for others.  This paper really formed a lot of my thoughts on why I should either be using a quant strategy or just be passive in my investing approach.

The paper is full of great insights – but my favorite is the analysis they did of stock picking performance relative to confidence in the outcome.  Here, they measured both students/lay people and professionals.  The outcomes are truly eye-opening – in this first chart, you’ll see that the students bested the professional in accuracy, but did so while having a lower confidence rating.  In other words, the professionals were both cocky and wrong.

ss_graph1

This one is great as well – it shows what perfect calibration on stock picking accuracy is as confidence rises, and then it shows both lay people and professionals.  While the lay people are static, the professional actually get worse as their confidence goes up.

ss_graph2

Anyway – it’s a great read – hope you enjoy it as much as I did.

In a related continuing story, fund managers continue to underperform the market.  Shocking!  😉

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Opaque
Image by jurek d. via Flickr

I’ve been crazy busy with my day job and Max – so my apologies for not posting more – that’s just the way it is at the moment.  But in the meantime, I wanted to post a little diatribe I’ve been thinking about.

I’m going to start with a generalization – people that are used to investing based on typical investment metrics (Cash flow, earnings, etc) have a strong distrust of black-box quant strategies.  I’ve seen it first hand.

But here’s my question: for the outside investor, why do they find it comforting that they have invested with, say, a value portfolio manager vs. going with a quant fund?  The answer is pretty obvious: they think they understand what the value PM is looking at, and, more importantly, they have faith in the particular set of metrics that the PM uses.

I’ve read a lot of detailed fund prospectus (some from very large hedge funds), and I find them all pretty, well, general.  “The portfolio manager selects stocks based on value metrics such…blah, blah, blah.”  So why on earth would they have confidence in this methodology?

The answer of course is performance.  This is why people chase performance.  They see a hot hand and they move in.

But in my mind, they have no greater understanding of what the fund manager is doing than in a quant fund.  So given that, is it even important that you understand how a quant fund works?  Isn’t the only judgement the performance?  And even if you did know what the value or quant portfolio manager was doing, how would that help you?  Would you give them a call and say “hey, I know how to fix your issue!” and expect them to welcome the critique with open arms?

I guess what I’m saying is that if you’re investing with someone else, it doesn’t matter if they are a human or a black box quant strategy – they are both equally opaque.  It is just that the value PM has the illusion of being understandable, and the quant strategy has the reputation of being either voodoo or genius.

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