Capital Market Assumptions - Part I
The Slipstream of Correlation
A few years ago, I was hired by a Registered Investment Advisor to create model portfolios from his firm’s approved list of mutual funds. For simplicity, this discussion will not address exchange traded funds (ETFs) or separately managed accounts (SMAs) but will focus on the criteria I used that apply to all of them. For context, the traditional methods for evaluating fund managers will be summarized as follows:
Alpha – does the fund have a track record for outperforming its benchmark index?
Beta – did the fund experience more or less volatility than its benchmark index?
Relative returns – does the fund have a track record for above average returns among its peer group managers?
Style – did the fund stay true to its value, growth, large, small, fundamental or technical style category?
Expenses – does the fund have a lower expense ratio than its peer group managers?
Turnover – did the fund have a low volume of transactions for tax efficiency?
There are others, such as manager tenure and capture ratio, but you get the picture – it’s about “what have you done for me lately?” But with my assignment for this RIA practice, I didn’t consider any of that on first two rounds of evaluation.
Why? Because with the one singular metric I used, the rest would easily fall into place. I begin with four broad-market asset classes (including money market funds) and simulate those in harmony with the cash flow expectations of the investor. And once the efficient asset allocation strategy has been determined, it is imperative to select funds that correlate as perfectly as possible to those asset classes.
Within this framework, it should be obvious that the primary metric for fund selection is the correlation coefficient of the fund to the benchmark indexes used in simulations. Naturally, a correlation of 1.000 is ideal – and if so, that satisfies nearly all of the questions above.
There is no alpha – and we never underperform. Beta is perfectly aligned – there is no deviation. Peer group rankings are average – because risks do not allow for high variability of returns. Style is inherently true. The low costs funds will have high priority – expenses are controllable. Tax efficiency is a given – turnover is controllable. In concert, these are the slipstream of correlation.
In summary, the traditional metrics are relevant when the product is the portfolio, but when the performance benchmark becomes the life of the investor, everything is reversed. And it works. Good theory is good practice. Always. To learn more, please click the link below:
https://www.amazon.com/Moneyball-Method-Middle-Class-Manifesto-Objective/dp/1696009111/