Markets

Money managers: Are you smarter than the market?

By Robin Mordfin     
June 11, 2015

From: Magazine

According to a Standard and Poor’s report from last June, only two out of all 2,682 actively managed mutual funds in the United States beat the market for five successive years. Wealth managers eager to improve those odds may want to try out a model that takes into account their level of confidence that they can beat a benchmark index.

Managers currently use a variety of methods to gauge their own ability to beat a benchmark, says Chicago Booth’s John R. Birge. Along with Luis Chavez-Bedoya of the ESAN School of Business, Birge created a model to help managers do this more precisely.

“How much do I as a manager believe in my view of the future of the market as opposed to a benchmark like the S&P 500? While I likely have great faith in my own thinking, I’m probably not 100 percent certain,” Birge says. “The model allows me to pick out the best combination of assets based on what I think is going to happen plus what the benchmark predicts. So I might go with a 50/50 view, or a 70/30 view, depending on my confidence.”

Birge and Chavez-Bedoya’s model seeks to provide a “consensus” view for managers to use when selecting assets for their funds. To use the model, a manager has to identify what the benchmark predicts would happen in a market, based on an extrapolation of past performance. She would also determine where she sees the market going in the same period.

For example, she might believe that health-care stocks are undervalued and that prices in the sector will rise for the next year relative to the benchmark prediction. After determining how much confidence she has in that view, versus what the benchmark indicates will happen, she selects a ratio to represent her confidence level and inputs it into the model, which provides guidance on how to distribute assets.

Birge believes that this improves upon other attempts to model manager confidence, most notably the Black-Litterman version formulated in the early 1990s by Goldman Sachs’s Robert B. Litterman and the late Fischer Black, who had previously worked at Chicago Booth and MIT.

That model is problematic for two reasons, he says. It assumes that gains and losses in the market are effectively symmetrical—a notion that researchers have since corrected. Moreover, “it also only provides for skinny tails, or small chances of large consequences,” Birge explains. “Our model provides for greater extremes (fat tails) as well as more strongly negative outcomes when things are bad.”

Birge and Chavez-Bedoya believe their model is more robust and for the same amount of risk offers better returns.

Works cited

John R. Birge and Luis Chavez-Bedoya, “Modeling Manager Confidence in Forecasted Excess Returns under Active Portfolio Management,” Journal of Asset Management, December 2014.

Fischer Black and Robert B. Litterman, “Asset Allocation: Combining Investor Views with Market Equilibrium,” Journal of Fixed Income, September 1991

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