Setting The Record Straight on Style Analysis
Aug 15th, 2006 | Filed under: Performance, Analytics & MetricsBy: Barry Vincor, Dow Jones
Published:
This interview with William Sharpe is now well over a decade old, but contains many important observations by William Sharpe himself on active management, and the differences between returns-based and composition-based analysis of index-hugging and alpha generation.
Excerpts:
“Q: Critics of returns-based analysis love to tell stories about how Bill Sharpe analyzes a portfolio and says it contains this or that and then when you lift the hood, ‘lo and behold, there aren’t any bonds, or whatever.
A: What you’re talking ahout here is predominantly risk. It’s not so much a matter of how the manager did on average over the seven years but how he did in months when there was a disparity in returns. If you have a security that says on it stock right up there at the top in nice Gothic lettering but it seems to go down whenever bonds go down, there’s good reason to suspect there’s something about the economics of the company or the way the instrument is written that makes it sensitive to interest rates. And if you happen to not want any more sensitivity to interest rates in terms of the risk you’re taking, you better not buy that security.”
“Q: Are there circumstances in which people should prefer composition-based style analysis?
A: It’s only as good as the security model that you’re using. You have to have a model at the security level if you’re going to use that. Often times, people have a model that’s so implicit they don’t realize it is a model. The Morningstar model is you re in this box, that box or another box. But that’s a model. It’s a model in which each security gets assigned to one of nine boxes—if you include bonds and stocks they actually have 18 boxes. Each security gets assigned a one for one box as exposure and a zero for the other 17. That’s a model. It’s a factor model. And they use it appropriately, I’m sure. Is it a good model? Is there a better model? That’s an empirical issue.”
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[...] Traditional (CAPM) measures of active management have relied on the extent to which a fund is correlated to its benchmark. Then in 1992, William Sharpe took this notion a step further by regressing mutual fund returns against not just a fund’s own benchmark, but against several passive indices. [...]