What makes a skilful portfolio manager?
Ignore the sales pitches, advises Rick Di Mascio. Successful managers simply get more decisions right than wrong, and make sure their hits make more money than their misses lose
Skill is the foundation that the investment management industry is built on. Yet what is it and how do we identify it? These are easy questions to ask, but difficult to answer.
In fact, some believe they are so difficult to answer that asset owners have decided to stop looking, or perhaps are looking in the wrong places. They are voting with their feet by cutting back on active managers, particularly equity managers or, worse still, walking away entirely.
In conversations with asset owners it is clear that they believe that even if skill exists, they have no confidence in their ability to find it. It is perfectly understandable that in these circumstances they give up on the search, but it is a great pity as our evidence shows that skill does exist and it is possible to identify it.
In reality, this lack of confidence says more about the current process of finding skill than whether it exists in the first place. It stems from a general disappointment in the results derived from the traditional trawl through performance figures, or scripted questions about the ‘three Ps’ – people, philosophy, process. Why have these traditional approaches let so many down? Let’s start by analysing track records.
A recent Inalytics research paper demonstrated how utterly misleading track records are as an indicator of skill by providing evidence to show that even fund managers with no skill at all had managed to outperform their clients’ set Australian equity benchmark. They got lucky simply because their clients had instructed them to not own REITS – 5% of the benchmark – because of their own direct involvement at a time when the sector collapsed.
Of the 42 managers we analysed, 11 derived more benefit from this quirk than their own stock-picking skills. Seven had no skill whatsoever, yet still managed to outperform simply because of this client instruction. Had it not been for this lucky break these seven would have underperformed. To make matters
worse, some of them were even paid a performance fee for the outperformance. Now that is what you could call lucky.
Before turning to the evidence that skill exists, it is worth spending a moment on the ‘three Ps’. It is self-evident that it is essential to know who the managers are, and what they believe drives asset prices.
However, noting managers’ description of the ‘three Ps’ isn’t the same thing as knowing they do what they say and that their beliefs add value. The biggest problem is that every fund manager competing for business today is schooled within an inch of their lives in how to answer these questions, and thoroughly prepared and briefed ahead of any presentation.
Recently, one of our asset-owner clients told us that he had just sat through six presentations in which every one of the managers said basically the same things – even to the extent of how each of their carefully crafted incentive structures has been designed to ‘align their interests to those of clients’. The sentiment is commendable, but after six times it started to sound a bit hollow and gave the impression that they had all been reading from the same manual. The ‘three Ps’ are important, but have turned into a blunt instrument for finding skill.
Let us now turn to the question of whether skill exists and how to find it. We believe that it is much more effective to analyse what managers do rather than what they say. In this case, ‘what they do’ means every purchase, sale, decision to own a stock or exclude it from the portfolio – for every day as far as the data will allow. This process is akin to sports analysis. There isn’t a sportsperson anywhere in the world who doesn’t believe this process can’t identify their talent and help them train better. It’s the same for our industry.
Inalytics has analysed 760 equity portfolios from around the world and has observed that skillful Managers have the following characteristics. They:
• Get more decisions right than wrong;
• Are able to run their winners; and
• Cut their losers.
These are simple intuitive characteristics of skill that can be identified and measured. So let’s turn now to the evidence. Figure 1 shows the distribution of ‘hit rates’ – the percentage of decisions that managers get right – for the Inalytics’ peer group in terms of quartile rankings.
The median managers get less than half of their decisions right, and the upper quartile get more than half their decisions right. That might not be the 60% some had imagined or hoped for, but it is still more than half.
The second and third characteristics are expressed in the ‘win-loss ratio’, which compares the profit from the average good decision with the loss from the average poor decision. If a manager is able to find and run winners, this improves the average contribution from good decisions, and if they are able to cut losers this then reduces the losses from poor decisions. The higher the ‘win-loss ratio’, the more skilful the manager. Figure 2 shows the distribution for the Inalytics’ peer group.
This is a very typical result in that a value for the win-loss ratio above 100 indicates that the main source of skill for most managers tends to be in their ability to have their winners offset their losses. This is particularly true for the upper quartile managers.
In summary, the industry’s growing disillusionment with active managers says more about the process of finding skill rather than whether it exists in the first place. The evidence clearly shows that some managers do have skill. The issue for the industry is not that skill doesn’t exist but how to identify it.
Our evidence demonstrates that skill does exist, and, just as important, that it can be found by using the right tools and some simple common sense measures.
Rick Di Mascio is founder and CEO of Inalytics