When Erroneous Models Produce Better Results

Several weeks ago Jason Zweig wrote about an erroneous and failed model employed in the Transamerica Tactical Income Fund.

The SEC found that the quantitative models used to run the portfolio was put together by an analyst with no experience managing portfolios, and the firm did no testing of the models to ensure accuracy and that they would meet stated objectives. In addition, the SEC found that the model was full of errors in “logic, methodology and basic math.”

Maybe They Were Looking to Save Investors Money

So how did such a lapse happen? Why would anyone rely on a new analyst with no experience whatsoever to put together models, without checking them, to run millions of dollars? Maybe it’s because they were trying to save costs.

Maybe. But not the cost to the investor. The Tactical Income Fund charges between 1% – 2% per year management fee to investors. That is a hefty cost for any portfolio. Especially one that consists of 10 ETF’s run by an erroneous model.

Time to Pay Up

Transamerica settled with the SEC without admitting or denying anything. Given the gravity of the errors, how much do you think Transamerica had to pay investors for the losses they incurred?

If you said nothing, you were right. And that is because this heavily flawed model produced better results than over half of the funds in the space. Wait…what was that? Yes, this significantly flawed model actually performed better than models that had accurate calculations.

What Does That Mean to the Industry?

This is just another piece of evidence of how hard it is to beat the an index, and how much luck plays a role in outcomes. There are a few active fund managers that truly add alpha through their skill. But the majority belong to great financial marketing companies that consistently underperform their indexes after fees.

Active management can absolutely have a role in someone’s portfolio. However, it is incumbent upon advisors to look deep into the philosophy of the manager, and understand the methodology employed. That won’t be easy – it goes against our preference for mental shortcuts. But it is absolutely necessary if advisors are serious about recommending the right solutions for their clients.