After reviewing some differences between traditional statistics and data science, we present a modular machine learning framework for model validation which blends the two paradigms. Model validation is set up as a sequence of procedures, in which the output from one procedure serves as the input to another procedure within a single validation framework. An econometric model is used in the first module to classify data in an economically intuitive way. Proceeding modules apply data science techniques to evaluate the predictive characteristics of the model components. We apply the framework to the fundamental law of active management, a well-known formal characterization of portfolio managers’ alpha generation process. In contrast to standard applications of the law, in which it has been used to evaluate a manager’s existing active management process, we recast the law within his framework as a means to test investment signals for potential use, individually or collectively, in a manager’s investment process. To illustrate how this application works, we provide an example using the well-known Fama–French factors as test signals.
Joseph Simonian is the founder and CIO, Autonomous Investment Technologies, LLC and co-editor of the Journal of Financial Data Science. Previously Joe held the roles of Senior Investment Strategist at Acadian Asset Management and Director of Quantitative Research at Natixis Investment Managers, where he led the quantitative research and portfolio strategy for the Portfolio Research and Consulting Group. He was also a member of the investment oversight committee. Prior to working at Natixis, Joseph was the Principal Research Analyst at Global Institutional Solutions. He was also the Vice President of Portfolio Management at J.P. Morgan and PIMCO. Joseph gained his PhD from University of California, Santa Barbara, MA from Columbia University, New York, and BA from University of California, Los Angeles. Joseph is a noted contributor to leading finance journals and is also a prominent speaker at investment events worldwide. He is currently the co-editor of the Journal of Financial Data Science and Advisory Board member for the Journal of Portfolio Management and the Financial Data Professional Institute.