How do you assess the track record of a strategy in order to ensure the best possible future returns? The solution to this problem was discovered by former Guinness employee, William Sealy Gosset. He needed a cheap way to test the quality of barley for brewing beer and devised the t-value to tackle the problem of drawing conclusions based on a small sample size using a formula known as the t-statistic.
The formula can be applied to many industries, including finance, because investors often face a similar problem of not having an unlimited sample size. The t-value can be used to test the statistical significance of excess returns - the returns of a strategy relative to an index. The standard deviation of these returns is the tracking error (TE). Once the t-value is calculated, it can be compared to the t-statistic for T-1 degrees of freedom and a 95% significance level. The outcome of this can be determined by the standard t-tables.
If you apply this formula to Robeco Core Developed Markets* (Institutional Global Enhanced Index fund), which has an average annual outperformance since inception relative to the MSCI World of 1.17%, a TE of 1.09%, and IR of 1.08 and a >10-year track record, the t-value is 1.09*√10.1= 3.46. This is statistically significant; because the critical t-statistic for 95% significance is 1.86.
* The value of your investments may fluctuate. Past results are no guarantee of future performance.
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