Morgan Stanley IM: When Good Managers Stumble – How to Know When to Let Go (or Not)

KEY TAKEAWAYS

1. When investors see signs of “alpha decay” in a manager’s performance, they need to determine if it is permanent or likely to be reversed.
2. Terminating a manager whose performance later recovers costs the investor permanent capital losses due to short-term noise while keeping a manager whose “alpha decay” is permanent leads to long term losses.
3. New research by the Portfolio Solutions Group (“PSG”) provides a rigorous, statistically sound, quantitative approach that offers guidance for deciding whether to keep or drop managers.1
4. This paper outlines our approach through a framework that involves a statistical process control scheme known as CUSUM, or a Cumulative Sum Control Chart.1 CUSUM is a statistical method that has its roots in industrial quality control, which PSG has adapted for monitoring manager performance.
5. The PSG CUSUM framework enhances the CUSUM test process proposed in the original literature, from Philips, Yashchin, Stein (2003), by refining alpha estimation, adding peer group analysis, and including additional tests to evaluate the manager’s stock-picking abilities. It allows investors to focus on potential problems before they have any serious impact on the performance of the overall portfolio.

For the Full Paper, Click on the Link Below.

Important Information:

¹ The statements above reflect the views and opinions of only PSG as of the date hereof and not as of any future date. The specific approach mentioned herein has not been evaluated or tested by an independent third party.

² Philips, Thomas K. and Yashchin, Emmanuel and Stein, David M., Using Statistical Process Control to Monitor Active Managers (January 17, 2003).

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