Conditional Performance Evaluation, Revisited

Abstract

One of the most difficult challenges for investors is to assess whether a fund's performance arises from a manager's skill or is simply the product of chance.Track records by themselves are typically too short to distinguish skill from chance.Moreover, what shows up as alpha may instead be an artifact of a misspecified benchmark.The consequences of poor performance evaluation are significant.Investment managers are needlessly fired, and perhaps more often, unjustifiably hired.And the transaction costs associated with this turnover substantially and unnecessarily dilute investor savings.Another, more subtle, cost of unnecessary turnover exists.If managers operate at different levels of risk, then in the absence of reliable information, switching managers into and out of a portfolio is riskier than maintaining a constant exposure to them.We are thus quite fortunate that Wayne Ferson and Meijun Qian have revisited the critically important topic of conditional performance evaluation.Unlike the conventional approach to performance evaluation, which assumes that investment styles and economic states remain constant, this methodology compares a fund's returns with the returns of a dynamic strategy that matches the fund's time-varying risk exposures.It thus controls for a variety of biases that might lead an investor to mistakenly shift between managers.And as a nod to the more cynically inclined, conditional performance evaluation prevents managers from gaming less refined performance benchmarks.Although the methodology is quite sophisticated, Ferson and Qian present the topic in a style that is accessible to practitioners, and they provide sufficient detail to facilitate implementation of their models.Yet, they do not bend to simplicity.Even the most quantitatively advanced scholars will be satisfied with their rigor and their comprehensive review of the extant literature.Ferson and Qian present a compelling case for conditional performance evaluation, both conceptually and empirically.Managers who are truly confident of their skill should be eager to have it rendered transparent by conditional performance evaluation.And investors should be equally eager to move from a murky system that confounds alpha with shifting economic states to one that shines a light on true skill-or the lack thereof.The Research Foundation is extremely pleased to present Conditional Performance Evaluation, Revisited.

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