Are "growth" asset managers more dexterous than their "value" counterparts?. Ronald Surz is president of PPCA, a San Clemente, Calif.-based software firm that provides advanced performance-evaluation and attribution analytics, and a principal of RCG Capital Partners, a Denver, Colo.-based fund-of-hedge-funds manager.

What's wrong with this picture?

|image1|Annual investment-performance reviews are showing that value-style investing has recently outperformed growth-style investing. They also show that, generally, investors would have been better off with passive-value indexes over active-value managers, but that the reverse is true for the growth style because active-growth managers have generally beaten growth indexes.

What is going on here? Are growth managers more skillful than value managers? The answer lies not with skill but with faulty benchmarks.

The benchmarks shown in most performance evaluations are incorrect, and when they're shown in a peer-group setting they're wrong for most of the funds in the peer group. It's the old garbage-in-garbage-out, or GIGO, problem. We view this common practice as something akin to phlebotomy, or bloodletting -- another dangerous but common practice of its day. To correct this problem, we advocate something called ideonomy, the science of ideas or the art of innovation.

The art of bloodletting

The picture on the right depicts George Washington dying from a cure that was much worse than the disease. |image2|The cure for Washington's flushed condition, the result of a bad cold, was bloodletting. The best doctors of the day were determined to rid the president of his red face -- and they succeeded, though with regrettable consequences.

The investment-consulting industry is in a state of metamorphosis similar to that which gripped the medical profession in the late 1700s. Like these physicians of old, investment consultants today are working in a profession still very much in its infancy. Common consulting practices that prevail today, like medical practices at the turn of the nineteenth century, have track record of failure. Investment consultants do a worse job selecting and allocating to investment managers than individual investors -- much as old-time doctors were hard pressed to beat the ministrations of untrammeled nature. This is due in large part to the blood-letting-like practice of benchmarking against indexes and peer groups. Only this the "patient" -- the client, that is -- is bleeding money because these benchmarks shroud rather than spotlight manager skill.

Fortunately the future is now. We have at hand the means to stop this financial phlebotomy and turn instead to ideonomy.

The science of new ideas

"The significant problems we face cannot be solved at the same level of thinking we were at when we created them," said Albert Einstein.|image3| In other words, think outside the box. We can't solve our benchmark problems with popular indexes and peer groups, because they are the problem.

Here are a couple of ideas that actually work, even if they're not yet common practice.

Develop custom benchmarks by combining indexes that, unlike current popular indexes, are mutually exclusive and exhaustive. In his seminal paper on effective asset mix, Nobel laureate William Sharpe recommends the use of mutually exclusive and exhaustive indexes to form custom benchmarks. 
Replace biased and misleading peer groups with science, namely Monte Carlo simulations (MCS) that provide a reasonable representation of all of the portfolios a manager could have held in constructing portfolios from the constituents of an appropriate benchmark. MCS is accurate and timely, and provides indications of statistical significance in a much shorter period of time than benchmarks alone.

These two choices - phlebotomy or ideonomy-- are summarized here.

Phlebotomy v. Ideonomy

Common practice

Bestpractice

Indexes

Custom benchmarksBlend mutually exclusive and exhaustive style indexes

Peer groups

Custom opportunitiesSimulate feasible implementations of manager's strategy

Actually there's a third choice: stop providing investment performance reviews, period. After all, anything worth doing is worth doing well -- and anything not worth doing well is best left undone. -FWR

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