ESSAYS
Insights from the application of Behavioral Finance.
SMART THINKING & BEHAVIORAL MATTERS ARE ESSAY SERIES WRITTEN SPECIFICALLY FOR PROFESSIONAL INVESTORS AND PORTFOLIO MANAGERS.
FEATURED ESSAYS
Going Beyond Hunches To Identify Skill
The absence of an industry-wide definition of skill is a serious problem. It makes the identification of skilled managers nearly impossible. It makes equity allocation decisions much riskier. It undermines the confidence of those working hard to identify top equity managers. It causes angst, fear, and avoidance that is unnecessary, which further fuels the reallocation of capital to passive equity products. Formulating meaningful ways to discuss skill is long overdue. So, let’s get started right now.
Where To Look For Skilled Equity Managers
Skepticism regarding the existence of skilled equity fund managers is understandable. In most years the majority of actively managed equity funds underperform.1 Among those that do outperform few manage to do so for 3, 5, or 10 years in a row.2 Then there is the direct experience that most asset owners and allocators share: conducting a search for a new equity manager, performing rigorous due diligence, establishing a short list, selecting the final candidate, and making an allocation. Then watching with a mixture of surprise and dismay as the once high expectation fund delivers quarter after quarter of underperformance. It is no wonder why so many institutional investors have grown timid about allocations to actively managed equities.
Assessing Manager Skill – Shifting from Guessing To Knowing
Sorting out which equity fund managers are skilled is arduous and expensive. Untold hours and huge budgets are expended each year in assessing the manager skill across existing allocations as well as the vetting of potential new opportunities. Even more concerning, however, is that skill assessment is an extremely uncertain undertaking. Consequently, the risks inherent to fund assessment as it is currently conducted are likely underappreciated by the majority of decision-makers. Results can include overconfidence and faulty allocation choices.
Active Share Is No Indicator of Manager Skill
Active share is used regularly to assess manager skill. It’s based on the belief that high active share is correlated with a fund’s ability to generate excess returns consistently. This understanding, in turn, has led to the inference that high active share funds are led by skilled managers. This has placed active share on many equity fund search checklists. It has also contributed to its presence within the marketing materials of numerous equity funds.
Broadening Diversification To Include Skill
Asset owners and allocators are now looking to fund manager skill as an additional source of risk diversification. Considering basic skills (buying, selling, sizing), length and amplitude of a manager’s alpha time horizon, and effectiveness in managing substantial losers are being integrated into more and more fund assessment processes. The results include greater insights into manager skill, more confident allocation decisions, and capturing more consistent excess returns.
Making Active Equities More Stylish
Style conformity helps asset owners/allocators know what to expect from individual funds and to manage their composite risk exposures. Strong adherence to style, however, reduces the degrees of freedom available to fund managers regarding the positions they can hold. The results from such constraints include selling positions well before their full excess returns are captured. This essay describes the strengths and shortcomings of style analysis and offers an innovative solution for how style can both help guide allocations without inhibiting fund returns.
Measuring Manager Skill Versus Fund Outcomes
Active equity investors want their capital in the hands of skilled managers. The reasoning is straightforward: Managers with the greatest levels of skill should do better than their less skilled peers over time, all other things being equal. Identifying who is highly skilled and who is less so, however, remains a difficult if not utterly impossible task for most investors.
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The multi-trillion dollar active management industry is predicated on the idea that managers have skill – yet little is known about it – Who has skill? How is it measured? This website is dedicated to finding answers to the questions surrounding skill.
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