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Old 08-05-2008, 02:51 PM   #41
BYU71
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Of course, its written by academics. If you think the studies are flawed then bring up problems with the studies. Just stating that they are written by academics is not a criticism. Point out flaws in the empirics.

Second, I have no problem with active management. Its fine ... its not going to make a huge difference on average. On average passive will beat active by a little not a lot and active has more chance for upside (someone may get very lucky and choose fund that happens to do fantastic). Of course, it also has a greater chance of a worse downside (relative to the benchmarks since passive by definition is basically the benchmark). In fact in aggregate we can prove passive beats active under the following two assumptions:

(1) Passive in aggregate holds approximately the market portfolio

(2) Active is higher costs then passive

If passive holds the market then by definition active also must be holding the market in aggregate because by definition passive plus active adds up to the market. If active is higher costs then by definition they must do worse because in aggregate the holding are the same: the market.

Of course, in any given period some active managers do way better than passive even controlling for risk. I have always agreed wit that. However, that really good performance in a given period is not usually a good predictor of future performance.
Basically there are some active managers who kick passive managing butt and have done so over long periods of time. Note, I said "some". Not all, not even most. Most managers actually underperform the average, which is true in about anything. I am sure you have heard about the 80-20 rule.

I will give you the high ground on theoretical arguments. I don't deal in that world and have no interest in it. That is the world of economists, who quite frankly also fall into the 80-20 rule.

If I find a manager who has consistently outperformed over the past 10 years, as for me, I will take my chances with that person over some theory. Like I have said over and over in this thread, it doesn't bother me if someone chooses to do otherwise.

Last edited by BYU71; 08-05-2008 at 02:53 PM.
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Old 08-05-2008, 03:07 PM   #42
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Basically there are some active managers who kick passive managing butt and have done so over long periods of time. Note, I said "some". Not all, not even most. Most managers actually underperform the average, which is true in about anything. I am sure you have heard about the 80-20 rule.
Yes you can find managers that have outperformed for long periods of time. I have never argued against that general idea. In fact Jay really wasn't making that argument either but I agree his original post suggested that he was in fact making that argument. 20% is too large but that hardly is an important part of your point.

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I will give you the high ground on theoretical arguments. I don't deal in that world and have no interest in it. That is the world of economists, who quite frankly also fall into the 80-20 rule also.
I assume economists are in the 80% but I am not sure I know how that rule applies to economists. Or maybe you mean only 20% of economists make any sense. That might actually be true.

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If I find a manager who has consistently outperformed over the past 10 years, as for me, I will take my chances with that person over some theory. Like I have said over and over in this thread, it doesn't bother me if someone chooses to do otherwise.
I don't think that's a bad strategy. Empirically on average a strategy for choosing funds with that heurisitic does fine (although not really better than other simple heuristics). Also such a heuristic can be perfectly consistent with portfolio theory. So in that sense your heuristic is probably a good one. It gives you a fund that probably in the end gives you a portfolio that is close to optimal in a portfolio theory sense but you are able to get to a near optimal portfolio without much hassle.

The implications of portfolio theory are hard to escape: once you tell me your care about the return and standard deviation of your portfolio, its really just math. Economics is flawed often enough, but math isn't.

Last edited by pelagius; 08-05-2008 at 03:21 PM.
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Old 08-05-2008, 03:21 PM   #43
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Yes you can find managers that have outperformed for long periods of time. I have never argued against that general idea. In fact Jay really wasn't making that argument either but I agree his original post suggested that he was in fact making that argument. 20% is too large but that hardly is an important part of your point.



I assume economists are in the 80% but I am not sure I know how that rule applies to economists. Or maybe you mean only 20% of economists make any sense. That might actually be true.



I don't think that's a bad strategy. Empirically on average a strategy for choosing funds with that heurisitic does fine. Also such a heuristic can be perfectly consistent with portfolio theory. So in that sense your heuristic is probably a good one. It gives you a fund that probably in the end gives you a portfolio that is close to optimal in a portfolio theory sense but you are able to get to a near optimal portfolio without much hassle.

The implications of portfolio theory are hard to escape: once you tell me your care about the return and standard deviation of your portfolio, its really just math. Economics is flawed often enough, but math isn't.
This is truly a question I will have to trust you will give me an unbias answer too. I don't know the answer. When we go back to long term capital, even though those guys were not using portfolio theory, they were using some sort of mathmatical theory to come up with all there conclusions on how to invest weren't they? I thought they were Nobel Economics winners from Stanford. Someone told me they were actually MIT.

While math isn't flawed, couldn't how you use the math and conclusions you come from in using the math be flawed?

The old joke about what is 2 plus 2 and the guy answers 4. No the answer is 22.
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Old 08-05-2008, 03:41 PM   #44
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This is truly a question I will have to trust you will give me an unbias answer too. I don't know the answer. When we go back to long term capital, even though those guys were not using portfolio theory, they were using some sort of mathmatical theory to come up with all there conclusions on how to invest weren't they? I thought they were Nobel Economics winners from Stanford. Someone told me they were actually MIT.
LTCM wasn't being run on a daily basis by academics, but it was, like most quant funds, relying on academic models and being run by academically trained people. There were a couple of famous academics involved with LTCM to some extent: Myron Scholes (Stanford) and Bob Merton (Harvard Business School). Both won the Nobel Prize for the development of the Black-Scholes option pricing formula (Black and Scholes were at Chicago when thet developed the formula).I don't know how heavy their day to day involvement was but I would certainly guess that they help developed some of the specific strategies.

Math wasn't those guys problem. It was the economics. They were using math but you can't say what they did was just math. They made some assumptions about the way the world should behave (all of which seemed pretty reasonable). In late 1998 the world didn't behave that way at all. Making assumptions about behavior and modeling how people behave is economics.


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While math isn't flawed, couldn't how you use the math and conclusions you come from in using the math be flawed?
Yes, people can use portfolio theory in a very flawed way potentially. However, what is usually happening is that they are overlaying additional economic assumptions on the basic theory. Its really those additional assumptions that can go wrong. Portfolio theory is a very general framework. There is no one "right" or "efficient" portfolio in portfolio theory (there are some dumb portfolios in portfolio theory but no one optimal portfolio or even optimal risky portfolio). When people get to one "right" or one "efficient" portfolio, they are adding addition assumptions that may or may not be good.

That said base portfolio theory can go wrong as well, but not because of the math. It would go wrong because of the economics. The economics of portfolio theory is that investors care about return and standard deviation is the right measure of risk. If those are bad assumptions then, while the math of portfolio theory is right, its not very useful. You have to buy into those basic economic assumptions. Once you do buy into those assumptions is just math: specifically its quadratic programming. Finally, there are implementation issues (I highlighted one of those early) that can cause problems.

Also, note that because its "just math" portfolio theory doesn't necessarily have strong implications. You can only get so far with relatively benign economic assumptions. At some point you have to take a stand to get strong predictions like, for example, beta being a good measure of risk. Portfolio theory would never by itself give that implication (portfolio theory implies the risk of a security is the following: cov(r_i,r_p) where i is some security and p is your portfolio, which implies the risk of a security may be different for every person because everyone may be holding different portfolios overall). Portfolio theory is just a framework and because it doesn't make strong assumptions it doesn't give precise implications. That's both a strength and a weakness.

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