Fund management is generally perceived as an art form where talent is beyond analysis and where the connection between skill and alpha is vague to say the least.

Yet we know from the work that we do with some of the leading fund managers and their clients that skills can be identified and are capable of objective analysis.

So what are these skills and what use is it to know whether you possess them?

The second question was answered most eloquently by Tiger Woods recently, when he was quoted as saying: “No matter how good you are, you can always get better.. You do not need to be a sports coach or psychologist to know that you can only improve your game once you understand what it is that you are good at and where the gaps are that need filling. And that this level of understanding can only be truly achieved through objective, evidence-based analysis.

In the past, the first place we would have turned to was the track record, but in reality it simply tells us how funds performed and whether they had met their targets or benchmarks. They say next to nothing about the investment process that produced the numbers or the manager’s strengths and weaknesses.

No wonder track records are notoriously volatile and are now subject to the inevitable risk warnings that they are no guide to the future. The warnings are right: they are a poor guide to the future.

Put simply, track records are a quantitative measure of how successful a manager was over a particular period of time, but say little about the fundamental issue of skill. Or to use a sporting analogy, they tell us whether they won or lost the game, but nothing about how it was played.

So what skills are fund managers expected to possess?

Ultimately, they are expected to possess three broad sets of skills. The ability to:

❏ Call whether the stock is expected to perform well or badly;

❏ Time the buying and selling decisions;

❏ Express their investment convictions effectively though the active weights in the portfolio.

All straightforward stuff and in some ways reasonably obvious. Yet our extensive analysis has shown that managers often fail to live up to these simple yardsticks.

Our research has produced some very interesting observations on the typical behaviour of fund managers when they are buying and selling. We have found that managers are much better buyers than sellers - no great shock to those who have spent time with managers and seen at first hand their natural optimism.

Empirically, we have found that the timing of buying decisions adds nearly 50 bps per annum to the alpha of the portfolio. Unfortunately, this is more than lost through poor selling which loses some 100 bps per annum.

So why is it that the same manager or investment process can be good at one side and poor at the other? For the answer we turn to the behavioural finance literature.

Prospect theory centres on the different attitudes to risk when investors are either looking at profits or losses. Consider the following examples:

❏ A choice between a guaranteed profit of $300, or an 80% chance of a $400 profit and 20% chance of winning nothing. Most people opt for the guaranteed $300 rather than take the chance of a higher expected profit ($320=80% x $400);

❏ A choice between a guaranteed loss of $300, or an 80% chance of a $400 loss and a 20% chance of losing nothing. In this scenario, most people prefer to run the risk of losing a higher amount (expected loss of $320=80% x $400) than to take a guaranteed loss.

Prospect theory, in summary, suggests that investors are risk averse when looking at profits but tend to be risk takers when confronted with losses.

Mental accounting points out that investors view each position within a portfolio as an entirely separate item and treat them in an inconsistent manner. In particular, investors tend to bucket ‘winners’ and ‘losers’ separately and the chances of something being sold increases simply if they have made a ‘profit’ on the investment.

Consequently, it is hardly surprising that potential winners are sold too early and poor performers are retained because they are showing a loss, particularly if the latter involves feelings of regret and loss.

These two observations clearly relate to each other and go a long way to explain some of the investment decisions we see on a regular basis, which often result in investors selling their winners too early and holding on to losers too long.

This is one of the key findings: funds regularly fail to run their winners and cut the losers. They do the opposite and it hurts.

 

Portfolio construction has come on leaps and bounds over the past 20 years with the advent of risk modelling and clearer client guidelines. But even in this much improved form, we have found that the construction process is not immune from common personality biases. These can put performance objectives at risk or simply waste opportunities to generate alpha.

Our analysis of 70 major equity portfolios has found that most fund managers demonstrate two key skills: the ability to pick stocks that outperform; and the ability to allocate them efficiently across their portfolios.

But the research suggests that managers struggle to identify stocks that are destined to underperform and consequently lose performance through their heavily underweight positions or decided against owning at all (the assumption being they will underperform over a certain period) then subsequently outperform.

This was true for nearly 75% of the portfolios analysed, and the negative impact was running into several hundreds of basis points. In fact only 5% of portfolios were losing performance through heavily overweight or ‘high conviction’ positions.

So, while the overweights usually added to performance, the underweights offset these gains and drag performance down. Over a 12-month period we found that the average contribution from heavily weighted positions was positive every single month, while the average contribution from underweight positions was negative in 10 months out of 12, leading to massive underperformance.

Again, this is despite the fact that fund management houses have processes for managing these ‘negative bets’.

This tendency seems to arise because of a well-documented behavioural bias known as the endowment effect. This is, in essence, a recognition that people value stocks more when they own them. When fund managers overweight a stock they spend a great deal of time on analysis, scrutinising every announcement, any change in the share price and any piece of information they find out about the company. Conversely, when a poor performing manager underweights a particular stock the same level of analytical
attention is not applied.

So why does it happen?

Managers have not invested as heavily in these stocks and therefore do not view them as being as important as their overweight stocks. We have found that fund managers have a tendency to become overconfident in their ability to identify stocks that they believe will underperform. Once they have made a decision, it is very difficult to get managers to change their minds, even when there is new information that may strongly undermine their
argument.

By studying their personality habits, managers can cut out the biases that have a negative impact, thereby boosting their overall performance. By identifying these particular traits, chief investment officers and heads of fund desks can ‘manage their managers’ more effectively and provide an assessment of performance.

The difference between poor performing managers and highly successful managers could be a series of finite decisions that may be pinpointed by objective analysis with hard data for managers to act upon and change their methodology.

Rick Di Mascio is chief executive at Inalytics, a provider of software consultancy to pension funds and asset managers

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