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How ‘skill’ is missing from performance discussions

Institutional and retail investors allocate vast sums to actively managed equities seeking alpha and additional diversification. Identifying managers likely to outperform going forward, however, remains a challenging endeavour for these investors. Today, these allocation decisions are exceptionally difficult in that they are made without benefit of a clear understanding of the skills and investment processes each manager possesses.

The need for clarity

Investors prefer to allocate to skilled managers – but exactly what is ‘skill’? And who has it? Answers to basic questions like these are not readily available. Conventional analytics such as attribution, information ratio, tracking error and upside/downside capture help explain how portfolio results were generated, but they do not quantify skill. Consider a fundamental equity portfolio which has generated a positive relative return for the past several years. Attribution analysis indicates positive stock selection for the portfolio which may lead some to infer that the manager is skilled at buying stocks. As intuitively tempting as this conclusion appears, it can be painfully wrong. Let’s consider how.

Assume that this portfolio holds positions for 36 months on average. Further, assume that the age of the positions held in the portfolio is evenly distributed such that the average age across all positions is approximately 18 months.

Additional analysis exposes that the manager’s ability to identify new stocks likely to outperform is moderate to weak – with only one-in-four new purchases generating alpha. Given this paltry success rate in buying new stocks, is it possible then for this manager’s portfolio to reflect a strong stock selection? Indeed, it is – and here is how.

When selling drives selection

Suppose the manager is able to identify within a few months of purchase which of their new buys is unlikely to generate excess return and sells off these laggards promptly such that weak buys stay in the portfolio only a few months while strong buys might be held for multiple years. The resulting portfolio would be populated more heavily by older winning stocks. Attribution applied to this portfolio would show a strong return from stock selection – driven by skilled selling, not skilled buying. This presents two related issues for the capital owner: 1. The manager may be perceived as possessing a strong buy skill which is incorrect; and 2. Should the sell skill weaken, portfolio results would drop, with neither the manager nor asset owner understanding why.

Quantifying ‘skill’

Skill is found in the actions taken by the manager. Within this framework, actions are defined as changes in position weights from one day to the next that cannot be explained by price movement alone. Such actions clearly identify buys, sells, adds and trims. Each type of action can then be aggregated and investigated as a unique skill.

Computing the buy skill starts with the creation of an alternative or counterfactual portfolio. The counterfactual initiates new buys on the same day they show up in the actual portfolio. These new stocks are then sized and sold passively. The result is a portfolio that reflects only the manager’s active buy decisions and none of their sizing or selling decisions. The relative return computed for this counterfactual portfolio quantifies the manager’s buy skill.

The tiebreaker

Asset owners commonly face choosing between managers that are virtually identical 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 similar active share and are evenly matched with regard to information ratio, tracking error, attribution and upside/downside capture. Choosing between these managers is frequently motivated more by gut-feel than analytic insight. Now, add further analyses into the mix from Cabot – a FactSet company – that shows one of the managers has a consistently positive buy skill and their portfolio history indicates a very consistent buy process, while the second manager has a buy skill that goes negative from time-to-time and their buy process is much more varied or suggestive of an opportunistic approach to sourcing new stocks. Armed with this additional information, asset owners may be inclined to prefer the manager with consistently strong buy skill and buy process. The thinking being that repeatable decisions are likely to result in repeatable results – all other things being equal.

Identification and allocation

Active equities remain a desirable asset class to retail and institutional investors. This enthusiasm is frequently met with the challenge of identifying which manager to whom the allocation should be directed using less than sufficient information. Traditional analytics offer useful insights into portfolio performance. They are far less helpful in enabling investors to understand manager skill or in supporting allocation decisions. Strong buy skill together with a consistent buy process are increasingly being seen as valuable metrics for assessing active equity managers. Fortunately, rigorous measures of skill and process are becoming more widespread with their availability from Cabot.

By Michael A. Ervolini, Director of Strategy, FactSet Research Systems, Inc.

Reference:

Ervolini, Michael A., “Managing Equity Portfolios: A Behavioral Approach to Improving Skills and Investment Processes,” MIT Press.

For more on this topic, see our whitepaper, “Active Share and Portfolio Concentration – Metrics Not Prescriptions”