Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Cabot Research and Bloomberg LP are co-hosting “Reviving Active Management: Improving Tomorrow, Starting Now” an industry conversation about the future of active management on Tuesday, November 11, 2014 at the Bloomberg headquarters in New York. To register to attend this event contact: [email protected]
Allocating client capital among actively managed funds is a difficult business. One approach is to follow the herd and put your clients with the other “hot money” in the market. The obvious shortcoming of this is that it is too easy to be the last one on the bus and find out that you’re once again buying high only to sell low. An alternate approach is to identify out-of-favor funds – the so-called contrarian investing. This style is suitable only when both you and your clients have the courage to plow capital into funds that are experiencing heavy outflows. The potential downfall to contrarian investing is that the other guys may be right; you might be loading your capital on a sinking ship.
Both approaches are based on hope as much as on real insight with regard to which funds are likely to deliver strong performance going forward.
The challenges of identifying superior funds is not unique to advisors or individual investors. Institutional investors also find this process vexing if not downright impossible. Institutional investors can rely on professional in-house staffs and benefit from the advice of independent manager search consultants. Even with such ammunition these well-heeled investors often misfire.
The overwhelming disappointment in picking skillful active managers fuels, to a large extent, the common perception that above average performance is due to luck rather than skill. Because, after all, if skill were involved then advisors and institutional investors would be better at picking funds, wouldn’t they?
Wrong! The fact is that despite years of wrangling over skill versus luck, no one really knows much about skill, and that is at the heart of the problem.
The search for skill
Here are the facts about investment skill: No one knows what it is. No one knows who has skill. And no one knows how to get more. This is a sad state of affairs indeed, yet participants on both sides of active management (managers and investors) continue to cling to metrics that are at best questionable and at worst downright obfuscating. There are indeed a great many metrics, including return, relative return, information ratios, alpha, tracking error, hit rates, win/loss ratios and attribution analysis not to mention Morningstar’s “stars.” All of these are simply scorecards – measuring manager performance over a period of time -- and that’s it. They say nothing about what the manager is best at or what she needs to improve. Most importantly, they do not inform the manager of what she can do today to be a more skilled investor tomorrow. And isn’t that the whole idea of improving? Knowing exactly what skill needs retooling and what precise actions to take is how top performers in all industries improve – except those who manage money.
Unlike individuals in other high-performance occupations (e.g., surgeons, musicians, athletes, jet pilots, etc.) portfolio managers work with extremely poor feedback. Conventional portfolio metrics hint at the presence or absence of skill but they fall far short of identifying its presence or quantifying its level. This leaves managers in the lurch. They want to improve but have very little insight into their skills.
Consider a professional golfer. If this golfer wanted to improve and all he knew was the score of each game, how would he do it? He couldn’t. He needs to know what part of his game is the strongest (drives, irons or putts) and what part is the weakest. With these facts, he could implement an improvement plan that would be very likely to work. This is why professional golfers have coaches and practice throughout their careers, even when they are at the top of their game. The feedback they have is so rigorous and granular that there is always a clear opportunity for them to become just a little better.
For managers, it is an entirely different story. The vast majority do not know the answer to this basic question: Do you generate more performance from your buys or your sells? As fundamental as this question is, managers don’t know the answer. And if you think that not knowing this answer is unimportant then think again. Some managers do generate the lion’s share of their performance from making great buys again and again. Others, however, make all of their excess returns from tremendous selling and/or position sizing. Not knowing which of your skills is strongest or weakest severely limits your ability to improve. You have to guess at what’s in need of retooling and then guess at what changes might help.
This is what managers face when they try to improve and it is the single biggest reason they have not been as successful as they desire. To learn more about how any of the three primary skills (i.e., buying, selling and sizing) can lift performance above the benchmark take a look at my book “Managing Equity Portfolios: A Behavioral Approach to Improving Skills and Investment Processes” from MIT Press.
Quantifying skills
My company, Cabot Research, has developed a new analytic framework that enables managers to quantify how well they buy, sell and size positions. These rigorous measures of skill are enabling hundreds of managers and research analysts to improve deliberately at this moment. This new framework also supports more granular investigations into sub-skills such as: Does trimming winners usually help or hurt portfolio performance? Does adding to losing positions typically pay off or not? The framework allows the manager to investigate aspects of the investment process (e.g., Is the buy process applied consistently?) and to quantify the negative impacts of behavioral tendencies. A few observations based on the application of the framework to hundreds of actively managed equity portfolios are presented below:
At least one behavioral tendency is found in 85% of portfolios that is highly persistent and costing the portfolio well over 100 basis points (bps) annually.
Most managers, even those who have been above their benchmark for years, possess at least one negative skill. It drains performance out of the portfolio year after year.
Selling is by far the skill most challenging to managers (relative to buying or sizing positions), and the skill that most managers are focused on improving.
Managing winners is more problematic than managing losers for professionals, with the two most common behavioral tendencies being the mismanagement of older winners (known as the endowment effect) and not feeding younger winners sufficiently (known as regret aversion).
How you can benefit
Start asking tough questions about skill and stop relying on scorecards. Funds that you consider should provide you with better information about the manager’s ability to buy, sell and size positions.
How does this help you? Here is your world today: You are considering two funds that are essentially equivalent in all aspects such as style, past performance, turnover, stewardship, fees etc. They both have identical Morningstar ranks and their current managers have similar tenure. Which do you go with? Which is the better bet to deliver excess returns tomorrow? Darned if I can tell. Can you?
Now let’s augment this scenario with more feedback. One manager has done well but his selling is barely positive, generating less than 25 bps of relative return annually. The second manager has impressive buying skills generating 130 bps of relative return year after year, for over a decade. And this is based on roughly 50% turnover across 100-plus names in the portfolio. In other words, the second manager’s buy skill reflects hundreds of buys, not just a handful. Does this additional information help differentiate these two managers? Is one of them beginning to look like a stronger bet?
This is the information that is needed throughout active management and it is needed right now. In order for you to recommend active products to your clients, you need to be able to make choices that reflect more than past performance, hope and a couple of stars. You need to better understand who has skill and who doesn’t and that is now possible with the help of the new framework mentioned above. Isn’t it time to step up your game for your clients? You can by asking tougher questions of the funds you consider and learning which fund managers have real skills and which are hoping that you’ll simply be star-struck.
Michael A. Ervolini is the CEO of Cabot Research LLc a company that helps equity portfolio managers improve.
Read more articles by Michael A. Ervolini
