Practical analysis for investment professionals
02 September 2015

Alpha Wounds: Bad Adjunct Methodologies

Active management has taken a lot of body blows recently. The principal criticism: Active managers contribute no alpha once their fees are factored in. So is it time to write active management’s obituary? Not quite. But active management certainly is feeling pain.

A few weeks ago, I argued that many of the alpha wounds plaguing active management are self-inflicted. But this month, I will discuss injuries to active managers that are not of their own making. Specifically, I will talk about those wounds resulting from the bad evaluative methodologies employed by the investment industry’s adjuncts: consultants, academics, research institutions, and so forth.

Volatility Is Not Risk

I began my analysis career working as an intern at Portfolio Management Consultants (PMC) in Denver, Colorado. Back then, among other measures, we utilized alpha, beta, Sharpe ratios, and Treynor ratios to quantify whether an investment manager was better than her peers.

Over time we started to notice something very interesting for which we could not account: namely, investment managers who beat their benchmarks handily in 17 of 20 quarters and had barely trailed their benchmark in the remaining three quarters. On a graph, this outperformance was especially dramatic. However, we would then look back to our list of quantitative measures — alpha, beta, and Sharpe and Treynor ratios — and see that these managers ranked poorly compared to those who had barely beaten the same benchmark over the same time period and who had led during fewer quarters. How can this be? This result — all too common in the investment management industry — is due to one simple fact: Volatility is not risk.

Yes, I have heard the argument that for investors entering and exiting funds, volatility is risk. But why is this the concern of the investment manager? Absent a lock-up period for an investor’s funds, how is the investment manager (active or passive) supposed to account for the anxiety of the end consumer? This is like holding physicians responsible for whether or not their patients smoke, drink, or eat hot dogs covered in trans fats. Or blaming psychologists for whether or not their patients continue to talk to their exes or take cruise ship vacations with the in-laws.

A Definition of Risk

The discussion of whether volatility differs from risk also depends on a critical assumption overlooked by most of the industry: Only in finance do we define risk as volatility. Different dictionary definitions of risk all converge on something like the “chance of loss.” Here is one such example:


  1. exposure to the chance of injury or loss; a hazard or dangerous chance
  2. Insurance
    1. the hazard or chance of loss.
    2. the degree of probability of such loss.
    3. the amount that the insurance company may lose.
    4. a person or thing with reference to the hazard involved in insuring him, her, or it.
    5. the type of loss, as life, fire, marine disaster, or earthquake, against which an insurance policy is drawn.


  1. to expose to the chance of injury or loss; hazard
  2. to venture upon; take or run the chance of


  1. at risk
    1. in a dangerous situation or status; in jeopardy
    2. under financial or legal obligation; held responsible
  2. take/run a risk: to expose oneself to the chance of injury or loss; put oneself in danger; hazard; venture.

Notice that not a single definition includes volatility as a part of its explanation. Dictionary definitions and popular understandings of risk might differ from a business definition, yet a popular business dictionary describes over a dozen different forms of risk, ranging from exchange rate risk to unsystematic risk, all of which focus on the chance of loss. The insurance business is an industry critically dependent on an understanding of risk, and an insurance licensing tutorial says that “Risk means the same thing in insurance that it does in everyday language. Risk is the chance or uncertainty of loss.”

Only in finance is risk defined as volatility. Why? In the early days of investment management analysis in the 1950s, academics recognized that average and standard deviation and the entirety of hundreds of years of statistics research thinking could be borrowed to analyze the performance of investment portfolios — if some of the definitions could be bent to their aims. Also, it was very difficult to run calculations of any sort in an automated fashion when calculators did not even exist and all computations were done by slide rule. So a simple measure was needed. Here, of course, I am talking about standard deviation. With standard deviation transformed into “risk,” the complex work of analyzing portfolios could begin and theories could be developed. Surely the math would take care of itself as the analysis was improved.

Take a look at the calculation of standard deviation and you will see that it is essentially the weighted average variation from a mean. There are two interesting things to note here:

  • Variations are both above and below the mean, so besting your benchmark handily is also called “risk” in finance.
  • Because larger variations from the mean are weighted more, any very large outperformance above your benchmark is even “riskier.”

These two facts illuminate how, back in the day at PMC, we found investment managers consistently outperforming (and when they underperformed, it wasn’t by much), but who would look bad from the point of view of alpha, beta, and Sharpe and Treynor ratios. So we developed investment management analytics at PMC that used a more accurate definition of “risk.” For example, we considered the return on US Treasury securities with the same maturity as the investment manager’s preferred investment time horizon to be the appropriate comparison for whether there was risk. Specifically, a manager’s return in a quarter was compared with the US Treasury. If the manager did not beat the Treasury, then it was characterized as a “loss” and became part of the time series used to calculate a downside-only standard deviation. We also adjusted the time series for each of our benchmarks as well for comparability.

Not surprisingly, this adjustment (among others omitted for the sake of brevity) began to highlight the performance of those truly outstanding managers rather than punishing them for terrific outperformance to the upside that the old measures said was “risk.” If you dig into the mathematics of alpha, beta, and the Treynor ratio, you find that they also punish managers who beat their benchmarks by too much. This is because the mathematics for all of these measures is sensitive to variability around a mean or trend line, rather than about only examining the downside.

Do Active Managers Beat Their Benchmarks?

But what does all of this matter? Don’t active managers underperform passive managers? It depends. Again, back in the day, I made it the focus of my masters program in business school to look at the performance of investment managers both using the traditional measures of “risk” and those metrics that I preferred. Guess what I found? If I used the traditional risk-adjusted return measures, I got the traditional result: Active managers underperform passive managers. Yet, when I used measures more like risk (the chance of loss), the average active manager outperformed the benchmark. In other words, the outcomes were reversed. This result held for multiple time frames. Subsequently, I updated this research while I was a money manager in 2003 (these results are proprietary to my old employer), and I found the exact same result as before. It would be lovely if someone would please update this research, don’t you think?

The Same Tired Paper

From where came the refrain about active managers not beating passive managers? If you trace many of the threads to their origin, you discover something fairly interesting: Most of these articles and stories all point to the same paper — and that paper was published a long time ago.

Here is one such thread: State Street’s Center for Applied Research and the Fletcher School at Tufts University recently published a white paper, entitled “By the Numbers: The Quest for Performance,” that reported that only 1% of active money managers deliver alpha after fees. What was their source for this oft-repeated claim? It was a 2012 article written by Charles D. Ellis, CFA, in the Financial Analysts Journal, entitled “Murder on the Orient Express: The Mystery of Underperformance.” Bad: This paper is three years old. Worse: The paper itself was not the original source of the data; instead, the data was from a paper written in 2010, entitled “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas,” that was published in the Journal of Finance. Worst: The return data used in this piece was only from up until 2006. The research also uses Sharpe ratios as the basis for its evaluation.

In other words, researchers and journalists are quoting nine-year-old data as the definitive coroner’s statement on whether active managers are better than passive managers. Furthermore, they are using measures of performance that punish upside outperformance in contradiction of most people’s definition of risk. Lastly, I know that passive strategies (most of the money in which tracks a well-published index) tend to perform better in up markets since these strategies encourage $billions to buy the same list of assets. I also know they tend to perform worse in down markets for the same reason. Would the results be replicated if the research used returns through the end of 2009? Hard to say, because such research is not often quoted if it exists.


So what can be done about this alpha wound, the one that is inflicted by the use of bad methodology on the part of the investment industry’s adjuncts?

  • Research into new measures of risk needs to be done. Sortino ratios are a start. But what are the full statistical ramifications of a semi-beta or alpha calculated on downside performance?
  • Once these measures are developed, then performance should be reevaluated for both active and passive managers — and after fees, of course.
  • Investment industry adjuncts need to stop quoting the same outdated research papers. It is the modern era and this data should be assessed in an automated fashion.

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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.

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About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor and the CEO of Active Investment Management (AIM) Consulting. Voss also sub-contracts for the well known firm, Focus Consulting Group. Previously, he was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. Voss holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: [email protected]

25 thoughts on “Alpha Wounds: Bad Adjunct Methodologies”

  1. M Ashok, CFA says:

    Hello Jason,

    The message in your article is simply great. The ETF/index market must grow on its own merits and not by taking potshots at active management. This has been my thought for sometime now and your article has reinforced that. But the passive investing evangelism has taken great heights and I am not sure how this will crumble down. Because there is no concept of under performance when the center of your universe is all passive products.


    1. Hello Ashok,

      Thank you for your very kind words! I really like your point that passive strategies must grow on their own merits. I include on that list of merits that they must demonstrate that they actually do beat active strategies based on a truly fair comparison. Depending on the comment stream on this piece I may propose some ways of executing this fair comparison. I also really like your point about there being no underperformance if all money is managed passively. If that were the situation then the definition of underperformance would once more shift back on to the client and whether or not they have achieved their goals. After all, isn’t it possible for a passive index strategy to not achieve a client’s goals? Say, for example that their goal was to earn an income, yet still retain equity exposure. A very naïve adviser might put them into a passive strategy having heard that such strategies are “the best,” end up defeating a suite of active managers, and yet not achieve the income goals of the client? This is an extreme example, but it shows that the client and her goals is the central axis of the investment business, and not just risk-adjusted returns.

      Thank you for contributing to the conversation!

      Yours, in service,


  2. Mike says:

    Hi Jason,
    Thank you for an excellent contribution to the unfortunately never ending defense of active management.
    The studies are also flawed in that talent is often not retained by the active fund industry. More importantly, the results of the remaining talent are diluted by 1.) the industry attracting mediocre managers due to attractive compensation and then retaining those managers due to inertia, etc.on the part of those slecting managers and 2.) the industry too often has a business focus (asset gathering) instead of an investment focus. How about a study that focuses on the subset of active managers that demonstrate: a value focus, low turnover, analytical rigor/insight, temperment awareness, loss avoidance etc.?
    Looking forward to more on this topic,

    1. Hi Mike,

      Yes, I think this debate is never ending, mostly because there is not an agreement on definitions and terms at the root of the arguments. Sound arguments based on flawed premises tend to be never ending : ) Regarding your point about talent…this just so happens to be one of the Alpha Wounds I will be addressing in a forthcoming piece. So clearly I agree with you, in principle. However, I had not considered the points you made, so thank you for making them!

      Regarding your study idea. I love this idea. I have a couple of ideas that would also help to redress the imbalance in comparisons between active and passive managers. Perhaps most importantly, I am well aware of a major study that is extremely strong evidence for the qualities (and investment quantities thus generated) by active management. This research is co-sponsored by a major US brokerage. However, I am not allowed to say more. Trust that I will be promoting it on social media once it is out.

      Yours, in service,


  3. Jamie Zhou says:

    Hi Jason, I do agree that the idea of volatility as risk is quite flawed, and loss versus risk free instruments should be the benchmark for considering how risky is an investment proposition. And I do think that some good investment methodologies might in the long run beat the market.

    But in considering specifically the question of active versus passive strategies, I find alluring the logical [not empirical] argument of how active investment, in aggregate, must match the returns of the market. And since all investors will, on average, only be able to match the returns of the market, then after cost, they will, once again on average, lose to the market return by the amount of their costs.

    Since a layman investor has no ability to find high performance managers who outperform consistently [perhaps because they are misled by metrics which do not properly capture outperformance as you have alluded to], or lack the ability to invest for themselves properly, they are better off being passive and just “buying the market”.

    Your comments please, thanks, Jamie.

    1. Hello Jamie,

      Thank you for your enthusiasm for the subject, and for your thoughtful questions. Here are some thoughts about those questions…

      * If you accept the logic of your own statement – “…how active investment, in aggregate, must match the returns of the market. And since all investors will, on average, only be able to match the returns of the market, then after cost, they will, once again on average, lose to the market return by the amount of their costs.” – then passive strategies will also fail to beat the market by their costs, too. Passive strategies are not frictionless relative to returns and they are a part of the “market,” too.

      Separately, whatever our definition of risk turns out to be, and as you know I reject volatility, there will be times when the “market” is riskier than active strategies. Most recently in the post-Great Recession environment active strategies outperformed passive ones specifically because active managers knew it was okay to hold cash, sell riskier companies, make choices based on valuation, and so forth.

      My point is that if we agree that a return vs. risk relative to a performance expectation, net of expenses is our standard of evaluation then there is nothing about that equation that says that active managers cannot beat passive managers. However, in that framework, and as most analysis of managers is done, passive strategies get a free pass on the risk frontier. Passive strategies certainly beat on fees, and that is another story and a legitimate question to raise of the active management community. But why isn’t it possible to have active returns in excess of the market? Which brings me to my next answer and point.

      * You used the word logic in the following way, “…I find alluring the logical [not empirical] argument of…” There are two logics that can be considered: abstract and practical. Your statement relies on the abstract/”in a perfect world” kind of logic. I surmise it is something along the lines of the oft-heard and quoted statement that “the market is, by definition a zero-sum game.” That is, in an abstract sense certainly true.

      However, let me illustrate by example the important distinction between abstract and practical logic. I notice in your e-mail address a flying/driving reference, so I hope this example resonates. By abstract logic there is no reason to test the performance of an airplane/car in a wind tunnel, or to have test flights/drives, or any form of testing, because in a perfectly abstract, logical sense we understand the mathematics of aerodynamics and forces of nature. We know the plane/car will fly/drive. Of course, hopefully, the error in this logic is obvious.

      Practical logic suggests that we cannot solely rely upon mathematics and abstract logic for evaluation. Why? Because the world is far more complicated than our equations would seem to indicate, logically (and abstractly). Instead, everything engineered has variances and tolerances built into it because we recognize, what? That the world is far more complex than we can acknowledge through pure abstract logic.

      Put another way, practical logic will always trump abstract logic. Why? Because practical logic is more inclusive than abstract logic. Because of its inclusiveness of practical considerations, practical logic proves it is inclusive of abstract logic. That is, abstract logic is a sub-set of practical logic. The reverse, in the extreme, cannot be said. In fact, the entire reason for using abstract logic is to simplify the world and to the degree to which we gain illumination from the simplification. This, by the way, is one of the reasons why we had a 2008-2009 financial crisis: models built on abstract, not practical logic.

      So with that preamble let’s return to your point about the (false) deity of finance and economics: The Market. I would argue, and I think I would win, that no one has transparency into the abstract concept of “The Market” that is necessary for the argument: “the market is, by definition a zero-sum game.” What qualifies here as “The Market?” If the S&P 500 is “The Market” – as it is for many, then all that is necessary to violate this as a proxy for the “The Market” is to identify some asset not in the index. What if we take every equity on the planet and put it into an index called “The Market.” OK, so now what if I buy a single fixed income instrument? Then clearly the “all inclusive” is not. So now we construct an index that is all equities everywhere and all fixed income everywhere. But what now happens if I buy some options, or short some options, or I have art, or gold, or a patent, or an education that I can monetize into money, or…hopefully you get the idea.

      Yet, there is more. There are two assumptions underlying the abstract logic of “The Market” that no one ever discusses. The first assumption is that everyone in “The Market” is fully invested. If I have any amount not invested – not even in a money market security, just a currency amount living as an electron in a bank – for even one down period that exceeds my fees, then I beat “The Market.” The second unspoken assumption: everyone is invested always. If there are any time lags in my portfolio, like I retire or I die, then I am no longer invested, and if this happens in a down period and this period is of sufficient duration then I can justify my fees.

      In short, where is this “The Market?” Using abstract logic, I know exactly where this “Market” is because by definition I can say something tricky like, “The Market is anything in the entire world that someone might want to exchange something of her’s for.” That “The Market” I understand, but practically, where is this “The Market?” How do I buy it? If the S&P 500 is my benchmark, not my investible universe (see last month’s post), then all I have to do to beat the index is to buy an S&P 500 ETF and buy one asset that goes up by more than the fees I charge. Alternatively, all I have to do is to buy an S&P 500 ETF and short one stock even within the S&P 500 that goes down by enough to cover the fees I charge. OK, you say, but the S&P 500 is not “The Market”. Whatever you choose as “The Market” all I have to do to beat it is to identify one asset outside of that definition that outperforms to justify my fees.

      * Next, it is not an oft-covered topic, and in fact, to my knowledge I am writing of it here for the first time, but there is not just a “market” for returns, there is also a “market” for risks. Why can’t an active manager beat “The Market” when he gets the choice of which returns to buy in “The Market” and also which risks to buy in “The Market?” By definition, “The Market” includes the full suite of returns – the part that defenders of the passive community like to discuss, but what they don’t discuss is it also includes the full suite of all of the risks of “The Market.” Ouch! I don’t like that kind of symmetry. I would much prefer a unit of return in excess of a unit of risk, wouldn’t you? With “The Market” you get it all.

      * I am not sure if you read my piece from last month about the bizarre concepts meant to enforce an odd definition that forces everyone to toe the benchmark line, but if these concepts are abandoned, then the world I just described above is much easier. Since we engaged in abstractions above, let’s engage in another one: Imagine a world in which active managers are actually active managers and they manage for the equation I described above, “a return vs. risk relative to a performance expectation, net of expenses is our standard of evaluation.” One of the reasons I have undertaken this article series is specifically to address the bizarre state of the investing world in which we find ourselves. There is no quick solution because the problem is a lack of thoughtful, conscious engagement with the world on the part of the investment community over the course of many decades. I believe that the active management community has hell to pay (see future articles, and last month’s, for example), but that does not mean that adjuncts and passive management get a free-pass either.

      * You are entirely correct to point out that the average investor cannot identify the outstanding manager. But is this the problem of the active manager, or the problem of the investor and his/her advisor? I would argue that the individual investor bears most of this responsibility. I think that our industry has done a poo-job of helping individual investors identify quality investments designed to help them achieve their goals. But this is outside the scope of what I am writing about here. Also, until we get the evaluation of these things correct in terms of philosophical foundations, how can we with confidence point investors toward anything with any sense of certainty?

      Now some questions back at you…What are your definitions of: “index,” “passive,” and “the market?”

      Yours, in service,


      1. Jamie Zhou says:

        Hi Jason,

        Thanks for your detailed, thoughtful and indeed thought provoking reply. Your reply is worthy of being an article in its own right, questioning some of the ideas behind passive strategies.

        I myself am an active investor and so I appreciate the debate over whether there can be any sustainable outperformance over the long run. Clearly I believe it is possible though I also think that passive indexed strategies can lay a solid foundation for a portfolio. I just want to respond on a few points:

        I do acknowledge that passive strategies are not frictionless, involving management fees and trading commissions [and taxes], though in a buy and hold strategy, both are modest. I do believe that active managers really need to “earn” their salaries and be symmetrically rewarded or punished relative to their performance to their benchmarks. Otherwise they are not adding value and indeed are subtracting value.

        Your point about what is The Market is a crucial one. As you have pointed out, the market as a whole is not an investable benchmark since it includes all sorts of assets including art, wine, or for that matter farmland and other hard assets that are not properly replicated in the form of an investable index. Perhaps the financial engineers may be able to find a way to do it though this might end up being a net negative event rather than a positive one.

        I too am perplexed by the use of tracking error as a performance criteria for active money managers. It is almost schizophrenic for investors to want outperformance and yet at the same time want a close adherence to benchmark performance. It is a contradiction. I find it hard to understand why they don’t just in this case go to an index fund.

        As for logical premises, you are right, they need to be tested to reveal misunderstandings over premises and assumptions. Rational and efficient markets are not always the case, at least in the short term. In the long run, it seems to me that investors must believe that the market eventually “gets it right”, since otherwise it will make no sense to invest at all since it becomes a game of chance.

        Thanks, Jamie

        1. Hi Jamie,

          Love your reply! Thanks for taking the time to expound on your thoughts. I am hopeful that many more such conversations take place in the industry, and in partnership with adjuncts (as I have been referring to them).

          Yours, in service,


  4. Ron Surz says:

    Many know the Sortino Ratio which defines risk as semi-variance, namely the risk of not achieving your desired return objective. What most don’t know is that Dr. Sortino created a company to help advisors manage downside risk. Dr. Sortino recently retired and I have succeeded him in Sortino Investment Analytics. It’s a multi-asset optimizer that uses active managers where it finds skill, and fills in with passive in market segments where skill has not been found.

    1. Hello Ron,

      Thank you for letting the audience know about SIA.


      1. Ron Surz says:

        Thank you Jason for the stimulating conversation

  5. Cam says:

    Yes! When I began taking classes to become a CFA, I just stared dumbfounded that they were defining risk as volatility (I’m a statistician). That, among other things I found disturbing, led me to conclude that if I did attain my certification, I’d lose it quite quickly. Needless to say I stopped taking classes.

    1. Hello Cam,

      Thank you for your comment.

      I find it troubling that volatility (i.e. variance and standard deviation) continues to serve as a risk proxy. However, defining volatility as risk is standard in parts of the finance industry. Our CFA program is not intended as an endorsement, but instead is designed to provide financial professionals with a broad-based knowledge base in the industry. For example, E = MC^2 is a superior formula to F = MA, but F = MA is still taught. We do not reject science as a discipline because of this : )

      Yours, in service,


      1. Cam says:

        Certainly. I wasn’t rejecting CFAs, I was simply realizing I wasn’t going to be successful without compromising my beliefs when practicing. I could actually justify risk=volatility as long as I defined that risk as the risk if a client panicking, not following my advise and doing stupid.

        When it came to how a balanced portfolio was constructed however, I had much great qualms. I felt that recommending low-yielding bonds or commodities in order to satisfy formulas based on that risk definition would have been unethical, but not recommending them would have garnered me sanctions.

        1. Hi Cam,

          Thanks for adding more detail : )

          With smiles,


  6. chris says:

    * Much though it pains me to defend the ‘investing theory’ status quo…..
    The claim that “Only in finance do we define risk as volatility” is putting the cart before the horse. Surely academics were always perfectly aware of the long list of risks faced by an investor. But since much of their work focused on price volatility (variance, beta, etc) vs returns they started using the term ‘risk’ as a short-hand label instead of ‘price volatility’, assuming everyone would know that is what they were referring to. They did not define ‘risk’ to BE price volatility.

    * I agree that “the principal criticism is that active managers contribute no alpha once their fees are factored in”, but I don’t agree that these conclusions are dependent on the returns being ‘adjusted’ or ‘correctly adjusted’ for risk. Am I mistaken in my memory that the major reporter of mutual fund returns (??Dilbert??) uses actual returns? And the mutual funds still under-perform.

    Is not the point of measuring risk-adjusted returns to ‘explain’ the underperformance?

    * I’m glad to see above that my issue with ‘cash’ is gaining currency at long last. The existence of cash in a portfolio (i) destroys all the academic work measuring the returns of individual investors, (II) destroys the logic of William Sharpe’s famous article, and (iii) redefines ‘the market’.

    * Whether or not you benchmark returns that are risk-adjusted, the debate of active vs passive should not be determined by the professional money managers. They face a long list of headwinds not faced by retail investors.

    1. Hi Chris,

      Thank you for your comments and for adding to the conversation.

      If you look at the major papers from the academic community they are most certainly not looking at absolute returns. They are usually looking at measures that they believe incorporate definitions of variability. If you read Markowitz’s original work from the 50s he makes a case for standard deviation/variance as risk proxy. This was a conscious decision. In any case, regardless of the motivations, volatility is not risk. Borrowing your logic – “Surely academics were always perfectly aware of the long list of risks faced by an investor.” – surely the academics and practitioners that have also raised the concern that volatility is not the same thing as risk must know what they are talking about, too. If not, if it is just some academics understand this, then my point still finds an audience.

      Active managers contribute no alpha after fees…what time period are you considering? Which active managers, those in the US, those in Europe, those in Africa, those where? Your blanket statement requires some source, don’t you think? As I pointed out in the piece above, most of these narratives trace back to a paper that looked at returns through 2006. We are now 8.5 years past that moment. Research prior was not so indicting. Also, a key assumption of a claim, “active managers contribute no alpha after fees” is that active management is being done right, and well. In my opinion, it is not, and this will be the focus of additional articles in this series. For this, the active management community has to come to account. Last point on this issue…passive investing is the greatest, self-reinforcing momentum strategy ever devised. To me, any apples to apples comparison has to factor in the momentum factor of “Hey, everyone, buy this list of assets because it is on someone’s list to track these things!” I am not entirely sure how to separate out the momentum factors, but this research has to be done in order to make truly fair comparisons, why? In the era in which a massive population bubble has saved for retirement (Baby Boomers the world over) and many have been swayed to invest in index funds and to dollar cost average and to contribute to their 401(k)s there is wind in the index fund sails. Yet, we are about to go through an extended period of demography where the two generations following Boomers are much smaller. Will the wind still be in the sail? If there is not wind in the sails, you are likely to have long periods of sideways to down markets. In a declining market you will not want to be invested in the index.

      Next, I am not familiar with your issue with ‘cash’ – please feel free to share with the group.

      The active versus passive is a discussion that all people in the investment industry should be engaged in having. Professional money managers are a part of that community and their voices should be heard. As should the voices of other communities. But if these voices are to have power then they must also be accountable. Poor measures of success are especially vulnerable to criticism.

      Yours, in service,


  7. Dirk Johnson says:

    Yeah, i guess S&P’s SPIVA reports must be “wrong”….just because the overwhelming majority of actual funds relative to their own stated benchmarks dont outperform, year after year, with actual real world data….means nothing to those paid to find “the wizards of wall street”….best of luck

    1. Hello Dirk,

      I am aware of the SPIVA findings and it is one of the reasons that I am undertaking this series of articles. Yes, active investors have some things to account for (hence the title of my series, Alpha Wounds) and many things that they do that I believe damage returns (see other articles in the series, like last month’s, and many more forthcoming). But the “volatility is risk” framework is not one of the things with which they need to answer.

      Also, that most researchers continue to point to outdated research papers is also not something for which active managers should answer. My point in writing this series is to dig into why investment returns, net of risk and expenses, do not benefit individual investors. I hope you think this is a worthy topic.

      It sounds like you are an investor who has concern about the success of your investments, yes? It also sounds as if you have some opinions that you would like to share and the floor is yours. In particular I would like to hear your views about passive investing and whether or not you believe it creates momentum effects. If you agree, then it would also be nice to hear your views about how to correct for these effects in performance evaluation.

      Yours, in service,


    2. Ron Surz says:

      The S&P SPIVA studies are indeed wrong, as are the Morningstar studies on manager failures. Peer groups will mess you up. See

      1. Hello Ron,

        Thank you for your comment. Care to share any additional details of why you believe the SPIVA and Morningstar stories are wrong? It helps to keep the story in one place. Maybe even just a prelude to what lies behind your embedded link?

        Big thanks!


        1. Ron Surz says:

          The S&P SPIVA studies are indeed wrong, as are the Morningstar studies. These studies use peer groups. All peer groups have biases, but most do not know about the most insidious bias. Classification bias is in all peer groups. It results from the fact that peer groups all have funds that do not belong. This fact is easy to see if you look, although almost no one does. For example, Zephyr has produced style plots of all the funds in a given Morningstar peer group. If you’re looking at large value funds, you’d expect the members of this peer group to cluster in the upper left quadrant, but they don’t. There are several reasons for classification bias, but suffice it to say that this bias cannot be corrected. It’s inherent in all peer groups regardless of what the provider does. Classification bias is particularly pronounced and problematic in hedge fund peer groups. Hedge funds are unique. The word “unique” means without peers.

          Classification bias causes funds to win or lose because they don’t belong, rather than because they’re good or bad. In I show how I have predicted winners and losers long before the SPIVA studies are published. I can make these predictions because these studies have nothing to do with skill, & everything to do with the impact of classification bias.

          1. Hello Ron,

            What an excellent explanation…thank you for pointing out the problems. It is usually the case that when you peel back the layers of the onion that your eyes begin to water when looking at analytical methodologies. I myself, when a fund manager, went through much handholding with Morningstar to ensure that they continued to classify us in our preferred category. Much of their schema was based on analytical methodologies, rather than on listening to the manager discuss his or her strategy, and then state upfront the preferred benchmark.

            Separately, I wonder how much underperformance occurs simply of shifting classifications and hence managers having an exogenous source of ‘style drift,’ ‘tracking error,’ and other such measures?

            Again, thanks!


          2. Ron Surz says:

            Glad you like it, & “get” it Jason. The CFA Institute’s Benchmark Committee warns against the use of peer groups. But what should we use instead? Performance evaluation is a test of the hypothesis “performance is good.” In hypothesis testing lingo, peer groups are samples, and the fact is each sample is different. Callan peer groups are different than Russell are different than Wilshire, etc. What you really want is “perfect information”, namely all the possible outcomes from what the manager does. This is achievable today by running portfolio simulations that I call “Portfolio Opportunity Distributions”, PODs.

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