The “inertia test” compares the performance of a manager’s portfolio at year-end with what his or her portfolio would have returned if it hadn’t been touched at all during the year. Currently, managers are usually judged by how much their risk-adjusted returns beat peers. However, it can be hard to make accurate comparisons using that method, say Shahin Shojai, George Feiger and Rajesh Kumar in their April 2010 working paper “Economists’ Hubris–the Case of Equity Management.”
Preliminary indications are not looking good for active fund managers. The authors conducted an experiment in which they asked students to pick stocks and make changes to their portfolios over a three-year period (transaction costs included). Only one-third of those who took part beat the performance of the portfolio they started with.
The authors say the inertia test is a useful way to measure whether your manager is adding value. It should also discourage excessive trading inside portfolios, and the resulting transaction fees that cut into returns. Now, where did you put that remote control?