Geoff Considine

Looking For Value in Active Management

Hi Kyle:

I understand your reservations with respect to this issue. Should funds and stocks fall on the same risk-return continuum? This is one of the most fundamental questions out there and there is no perfect answer. If Bill Sharpe is correct with CAPM then the answer is no. But CAPM is really discredited at this point---there is just no real support for it in the data. FinancialEngines.com provides a model that follows the CAPM sort of model, though. All of the performance of a mutual fund is explained by the weights assigned to a series of sector indices. But does that make sense for individual stocks or for concentrated funds not represented in the ten or twelve indices? No--the results are poor as shown by Dr. Sharpe himself. I have discussed this issue in a an article published here and on my website. Also, there is no satisfying way to think about individual companies in this way. This topic goes very much to the idea of efficient markets--as you say--and I am not convinced that indices are efficient. Rob Arnott, for example, shows that fundamental weighting has out-performed cap weighting dramatically over long periods of time and there are a wide variety of other studies that suggest that broad indices are not efficient.

How, then, can we test a model? I believe that out-of-sample tests are the only way to go. If you look through my articles, you will find a range of out-of-sample tests that show that QPP and QRP perform quite well and add value for portfolio planning. These tests include a wide variety of portfolios. Better yet, I encourage users to do these analyses themselves.

I am not suggesting that I have all the answers--I have developed a tool that tests well and has been validated in a wide variety of market conditions. There are other approaches. If you are mainly interested in mutual funds and belive in CAPM, FinancialEngines may be more to your liking---check it out.