FactSet Research: How “competence” is missing from performance discussions
Institutional and retail investors are allocating large sums to actively managed stocks in search of alpha and additional diversification. However, identifying managers likely to outperform in the future remains a difficult task for these investors. Today, these allocation decisions are exceptionally difficult as they are made without the benefit of a clear understanding of each manager’s investment skills and processes.
The need for clarity
Investors prefer to invest in competent managers, but what exactly is meant by “skills”? And who has it? Answers to basic questions like these are not readily available. Conventional analyzes such as attribution, information ratio, tracking error, and upside/downside capture help explain how portfolio results were generated, but they do not quantify skill. Let’s take the example of a fundamental equity portfolio that has generated a positive relative return over the past few years. Attribution analysis indicates positive stock selection for the portfolio, which may lead some to infer that the manager is good at buying stocks. As intuitively tempting as this conclusion may seem, it may be painfully wrong. Let’s see how.
Let’s assume that this portfolio holds positions for an average of 36 months. Further, assume that the age of the positions held in the portfolio is evenly distributed, so that the average age of all positions is approximately 18 months.
Further analysis reveals that the manager’s ability to identify new stocks likely to outperform is moderate to weak, with only one in four new buys generating alpha. Given this paltry success rate in buying new stocks, is it then possible that this manager’s portfolio reflects solid stock selection? Indeed it is-and here’s how.
When selling the record selection
Suppose the manager is able to identify within a few months of buying which of his new buys is unlikely to generate excess return, and he sells these laggards quickly, so that weak buys do not remain in the portfolio for only a few months, while strong purchases can be held for several months. years. The resulting portfolio would be populated more heavily by older winning stocks. The attribution applied to this portfolio would show strong performance from stock selection focused on qualified selling, not qualified buying.
This poses two related problems for the capital owner:
The manager may be perceived as having a strong buying skill, which is incorrect
If sell skill weakens, portfolio results will fall, with neither the manager nor the asset owner understanding why.
Competence is found in the actions taken by the manager. In this framework, actions are defined as changes in the weighting of positions from day to day that cannot be explained by price movement alone. Such actions clearly identify buys, sells, adds, and cuts. Each type of action can then be aggregated and studied as a single skill.
Competence is found in the actions taken by the manager.
The calculation of buying competence begins with the creation of an alternative or counterfactual portfolio. The counterfactual initiates new purchases the same day they appear in the actual wallet. These new stocks are then dimensioned and sold passively. The result is a portfolio that reflects only the manager’s active buy decisions and none of his sizing or selling decisions. The relative return calculated for this counterfactual portfolio quantifies the manager’s ability to buy.
Asset owners typically face a choice between virtually identical managers based on conventional metrics. Consider two equity managers whose portfolios have generated similar returns, have the same style, hold a similar number of positions, reflect a similar active share, and are on par in terms of information ratio, tracking error, attribution and capture of increases/decreases. The choice between these managers is often driven more by intuition than analytical insight.
Now add more analysis into the mix from Cabot, a FactSet company, which shows that one of the managers has a consistently positive buying skill and his portfolio history indicates a very consistent buying process, while the second manager has a buying skill that turns negative from time to time and their buying process is much more varied or suggests an opportunistic approach to finding new stocks. Asset owners armed with this additional information may prefer the manager with consistently strong buying skills and buying process. The idea is that repeatable decisions are likely to lead to repeatable outcomes, all things being equal.
Strong buying skills coupled with a consistent buying process are increasingly seen as valuable indicators for evaluating active equity managers.
Identification and attribution
Active stocks remain a sought-after asset class for retail and institutional investors. This enthusiasm often comes up against the challenge of identifying to whom the allocation should be directed using insufficient information. Traditional analytics offer useful insights into portfolio performance. They are much less useful for allowing investors to understand managers’ skills or for supporting allocation decisions. Strong buying skills coupled with a consistent buying process are increasingly seen as valuable indicators for evaluating active equity managers. Fortunately, rigorous measures of skills and processes are becoming more prevalent.
This article was originally published by the Financial Times.
This blog post is for informational purposes only. The information in this blog post does not constitute legal, tax or investment advice. FactSet does not endorse or recommend any investment and assumes no responsibility for any consequences related directly or indirectly to any action or inaction taken based on the information in this article.