Weekend Reads from India: Measuring Manager Skill vs. Luck
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India’s rapidly expanding mutual fund industry is currently undergoing momentous change. Mandated regulations announced late last year will require mutual fund companies to follow a new standardized classification system. Mutual fund performance reporting changes will come into effect at the beginning of May. This is the first time that a reclassification of this scale has occurred in India, and it will take some serious time and effort to understand the reorganized information canvas.
Simplifying fund classifications is a global regulatory best practice aimed at making it easier for investors to choose among the funds available to them. Importantly, it also helps reduce misselling opportunities. In the short run, however, the market place will face a range of adjustment issues and unintended consequences.
The simple changes to fund strategies that result from the standardized (re)definitions are easier to deal with. These changes are marginal and include nominal differences between the existing fund strategies and regulatory definitions. For example, a mid-cap fund will have to hold “mid-cap stocks,” which are now defined as listed companies with a market-cap rank between 101 and 250. Existing (old) mid-cap strategies likely have different definitions of what constitutes mid cap.
The style impact of these changes is more difficult to assess. Unintended shifts in the factor tilts of newly constituted portfolios are likely and the new tilts may not correspond with the risk profiles of the investors in current strategies, say, if value changes to growth, etc. The new regulations provide guidance on any fundamental change in the attributes of a strategy. But ultimately any such change will also have to be aligned and understood at two distinct levels: fund manager skill and the risk-return profile investors need.
Another set of consequences has not received so much attention. Performance best practices, as outlined by the Global Investment Performance Standards (GIPS), require beginning-of-period asset weighting for computing past performance. Moreover, if the altered fund strategy differs from the earlier one, historical performance may no longer be relevant. The accurate merging of strategies and best-in-class performance reporting are critical to assuring the integrity of the data.
Ultimately, the performance record is the only means investment decision makers have to objectively differentiate between alpha that results from manager skill or simple luck. The distinction is difficult to determine, but accurate performance numbers can help.
An analyst’s performance is often seen as a yardstick to measure their ability. But it is much more than that. It can also help determine whether a potential client aligns with the manager’s decision-making process. Ex post facto, performance track records can be used to assess not just stand-alone suitability, but how well a given manager’s style fits alongside the investor’s portfolio.
Here are some readings I came across in the last few weeks. I hope you find them interesting. Happy Weekend!
Performance (Or the Lack Thereof)
Financial Markets
Value Investing
Other Fun Reading
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©iStockphoto.com/Ellica_S
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