Measuring the Effects of Foresight and Commitment on Portfolio Performance
39 Pages Posted: 23 Mar 2009 Last revised: 19 Aug 2009
Date Written: August 18, 2009
A central question in finance is how to measure portfolio performance. We assert that foresight (i.e., the ability of managers to forecast relative returns) and commitment (i.e., the aggressiveness with which managers act on their foresight) are necessary ingredients to generate portfolio performance not attributable to chance. We create two portfolio performance measures free from the need to pre-specify a benchmark portfolio. Our measures allow for many investment styles because they use benchmarks created from the style implied in the portfolio being tested. To calibrate these new measures, we use a weight-generating process that simulates various combinations of foresight and commitment. We decompose our measures to show how foresight and commitment act jointly to generate statistically measurable excess performance. An outcome of our measures is a scoring mechanism that groups portfolios by commitment, and then ranks portfolio performance by foresight. We apply our measures to a series of actual asset allocation recommendations made by a panel of Investment Houses. Largely, we find little foresight, but we document considerable aggression. The Investment Houses made allocation recommendations to equity, bonds, and cash. However, our measures easily generalize to a wide variety of potentially hard to measure investment styles, like those of hedge funds and other alternative investment managers.
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