Type I and Type II Errors in Manager Selection Process

Type I and Type II Errors in Manager Selection Process

Candidates may remember their inferential statistics training from CFA Level I. This reading delves deeper into Type I and Type II errors within the context of hiring and firing investment managers. It's important to note that the null hypothesis presumes the manager lacks skill, doesn't meet expectations, or underperforms.

Null Hypothesis: Manager Underperforms

Therefore, the two potential errors are:

  • Type I: Hiring or retaining a manager who later underperforms expectations. Rejecting the null hypothesis when it is correct.
  • Type II: Not hiring or firing a manager who later outperforms or performs in line with expectations. Not rejecting the null hypothesis when it is incorrect.

Another, perhaps simpler and less scientific way to think about these errors is:

  • Type I: Keeping a bad manager.
  • Type II: Missing out on a good manager.

Determining whether to avoid type I or type II errors in fund selection varies based on the fund sponsor's preferences. Many prefer steering clear of poor managers, in other words, avoiding type I errors. Here are a few reasons for this choice:

  • Financial market participants psychologically try to avoid regret. Type I errors create explicit costs, while Type II errors create opportunity costs. Many individuals give excess weight to explicit costs in their decision-making processes.
  • Type I errors are relatively simple to measure and are often directly linked to the decision maker's compensation. Type II errors are less likely to be measured since they represent a more nebulous opportunity cost.
  • Type I errors are more noticeable because they bring not only the regret of a wrong decision but also the challenge of explaining it to the investor. In contrast, Type II errors are less conspicuous.

While most investors often focus on type I errors, type II errors are also significant. Monitoring managers who were fired or overlooked can help fund sponsors identify weaknesses in their selection process.

The impact of type I and type II errors is generally smaller in more efficient markets. Market efficiency, especially its tendency to mean-revert, influences the costs associated with these errors. For instance, in a mean-reverting market, firing an underperformer only to see them bounce back represents a Type I error. Conversely, a Type II error would involve retaining strong performers and avoiding managers with weaker short-term track records, which also incurs costs.

Question

Which of the following most accurately describes a type I error?

  1. Rejecting the null hypothesis when it is correct.
  2. Not rejecting the null hypothesis when it is incorrect.
  3. Not rejecting the null hypothesis with it is correct.

Solution

The correct answer is A.

It describes a Type I error accurately. It occurs when a researcher or analyst incorrectly rejects the null hypothesis, which essentially means they conclude that there is a significant effect or difference when, in reality, there isn't one. This is also known as a “false positive.”

B is incorrect. It describes the correct decision in hypothesis testing. When the null hypothesis is incorrect, you should indeed not reject it because you're essentially saying that the data doesn't provide enough evidence to support the alternative hypothesis. This is not a Type I error.

C is incorrect. It is describing the correct decision in hypothesis testing. When the null hypothesis is correct, you should not reject it because it means that the data doesn't provide enough evidence to support the alternative hypothesis. This is not a Type I error.

Remember:

The null hypothesis is that the manager has no skill.

Performance Measurement: Learning Module 2: Investment Manager Selection; Los 2(b) Contrast Type I and Type II errors in manager hiring and continuation decisions

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop Graduate Admission Exam Prep


    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    2021-02-18
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    2021-02-13
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    2021-01-27
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    2021-01-14
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    2021-01-07
    Crisp and short ppt of Frm chapters and great explanation with examples.