Using Statistical Process Control to Monitor Active Managers

Abstract

Investors and chief investment officers who are invested in (or bear responsibility for) many products face a resource allocation problem. Which products deserve their attention and scrutiny? Ideally investors will focus on products that appear to be in trouble, but these are not easily identified using the classic methods of performance evaluation. In fact, it is often claimed that it takes 40 years to determine whether an active portfolio outperforms its benchmark. The authors demonstrate that a statistical process control scheme known as the CUSUM can be used to detect flat-to-the-benchmark performance in 40 months, and to detect underperformance faster still. By rapidly detecting underperformance, the CUSUM allows investors and CIOs to focus their attention on potential problems before they have a serious impact on the performance of the overall portfolio. The CUSUM procedure is provably optimal; for any given rate of false alarms, no other procedure can detect underperformance as quickly. It is robust to the distribution of excess returns, allowing its use in almost any asset class without modification.