New study says widely-used models can be particularly misleading in performance evaluation
Jul 14th, 2008 | Filed under: CAPM / Alpha Theory
It seems to have become a financial axiom that actively managed mutual funds fail to justify their fees. Ergo, index funds are often proposed as the best way to lose the least amount of money.
But what if the underperformance of actively managed funds has been driven by their underlying strategy, not their stock-picking buffoonery?
Beneath the complexity of their recent paper on benchmark indices, that’s the question posed by Martijn Cremers and Antti Petajisto of Yale and Eric Zitzewitz of Dartmouth. (You may recall the names Cremers and Petajisto from their paper on active share – a new metric to measure active management. See related posting.)
The researchers found that academic models aimed at isolating manager skill by adding new variables to the CAPM (such as the Fama/French and Carhart models) are a substantial weakness. Instead, they propose using actual indices as variables in an equation to reveal manager skill.
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Practioners would immediately classify the Russell 2000 as the ideal of small-cap returns, instead of SMB. Two problems retail investors encounter when replicating HML or SMB, that I’ve never seen addressed by academic:
1). They are equal weight indices (actually hybrids of EW and VW), and no retail index/etf is equal-weighted
2). DFA, the most likely source to replicate these indices does not short, so you couldn’t get returns associated with “ML” and “MB” from the the Fama-French epicenter.
One thing that’s surprising is how little momentum (”UMD”) has been emphasized as a security selection strategy in the ETF/Fund space.