Benchmarks are indispensable for investment analytics. The challenge is picking a relevant one. The stakes are high because the wrong benchmark can be worse than none at all. The good news is that the potential for error can be dramatically reduced by choosing a set of random benchmarks that are generated from a portfolio’s holdings.We are fans of randomness and not just in benchmarking. Previously:
As an example, consider a money manager with a mandate to beat the S&P 500 with an active strategy that targets stocks in the index. The standard approach is to compare results against the S&P 500. But there’s a stronger choice: generating thousands of random portfolios drawn from the S&P names.
Even when there’s a clear choice for benchmarking, comparing a strategy in the context of thousands of random but related portfolios offers a superior foundation for risk and return analytics. In the case of an active S&P strategy, the procedure is to create thousands of alternative portfolios by randomly varying the weights and rebalancing schedule.
Using randomly generated portfolios as a benchmark is an idea that’s been around for a while. Patrick Burns of Burns Statistics wrote a research primer on the topic in 2004 (“Performance Measurement via Random Portfolios”), noting that randomly generated benchmarks have advantages over the conventional approach. “The measurement of skill with random portfolios avoids some of the noise that is introduced when performance is measured relative to a benchmark,” he noted.
Another advocate of random portfolios is Ron Surz of PPCA Inc. Writing in the Spring 2007 issue of The Journal of Performance Measurement (“Accurate Benchmarking is Gone But Not Forgotten: The Imperative Need to Get Back to Basics”), he outlined the case for using Monte Carlo simulations to sidestep the limitations of traditional benchmarking and peer-group analysis....MUCH MORE
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That last piece of research was awarded Harvard's own Ig Nobel prize in 2010.
Ya see, ya got your complex systems and ya got your chaotic systems and then ya got your complex-chaotic systems like weather or the economy or the stock market and when you endeavor at those levels of sophistication you realize:...