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Section one: identifying Manager Skill
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recent study in America confirmed the finding that high school grades are themost accurate predictor of student success in the first year of college. This isimmediately intuitive. In a similar way, the past performance of investment managersis often imagined to be a useful predictor of future returns. In our industry, intuitiondoes not correspond with reality as a good period of performance is just as likely tobe followed by a poor one.This would not be such a problem were it not for the fact that even some of thesmartest Investors tend to disregard the evidence and their own bitter experience, andtreat track records as short hand for skill. “If they had outperformed then they mustbe skillful, and vice versa”.But given that reality is not that simple and track records have proven to be anunreliable predictor of future performance, is it little wonder that even sophisticatedPension Funds are left questioning if skill exists at all and, if it does, do they have thetools to find it?The extensive evidence from Inalytics’ database of Managers shows that skilldoes in fact exist. This implies that it is the traditional methods used to find it that arefailing the industry. Accepting that Managers have skill, but it is the tools used to find it that havelet us down, requires a radical change in the way we go about evaluating Managers.By turning away from track records, and towards an evidence based approachthat analyzes every decision a Manager takes to identify their real strengths and weaknesses, we have found the framework we are seeking.This methodology involves putting every investment decision under themicroscope to obtain a clear picture of a Manager’s DNA. In practice this meansanalyzing every purchase and sell, and every decision to include or exclude astock from the portfolio on a daily basis, so as to evaluate how well they constructportfolios and time trades.
Published by
Inalytics Limited+44 (0)20 8666 0656info@inalytics.comwww.inalytics.comCo-authors:Rick Di Mascio
Inalytics
Simon Savage
GLG Partners LP
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Identifying skill comes down to whether the:
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Overweight positions in the portfolio perform well
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Underweights perform badly
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Buys outperform
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Sells underperformThese are simple common sense metrics that establish whether the Manager istypically correct when they are positive on a stock and if they also have the ability toidentify poorly performing stocks and sell them before a period of poor performance.This process lays bare the facts: either the decisions added value on average orthey did not – end of story, no waffle, no excuses.The fundamental point is that a true evaluation of skill comes from a rigorousand detailed analysis of every decision a Manager takes so as to identify their realstrengths and weaknesses and where the balance lies between them.These are insights that are not available from looking at track records alone.
H rs h W lss rs – a Sp Up fm t rs
Shifting the focus from track record to decisions gets us closer to understanding thenature of investment skill, but it also creates the challenge of how to handle thesehundreds of thousands if not millions of decisions in a way that provides real insightsinto a Manager’s investment skills.Inalytics’ research paper No. 3 introduced the concepts of Hit Rates and WinLoss Ratios as an efficient and intuitive way of getting behind the track records.These two measures answer the basic yet profound questions of whether a Managergets more decisions right than wrong (Hit Rates) and whether the good decisionsoffset the poor ones (Win Loss Ratios).Simple intuitive questions that investors have been asking for a long time, butup to now the industry has not had the answer.In this paper we show that the average Hit Rate for the portfolios in theInalytics database was only 49.6% meaning that Managers don’t get 6 out of 10decisions right, as was previously assumed; the reality is much more pedestrian anddisappointing at slightly less than half of all decisions taken.This disappointing outcome is offset however by an average Win Loss Ratio of 102%, which implies that good decisions offset the poor decisions, albeit by a smallmargin.These numbers relate to the averages across all the decisions that Managerstake. However we have seen in a previous research paper, Inalytics No 1, that whenManagers have skill, it manifests itself in the positive or overweight decisions asshown in the following table.
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H rs W lssovwh
48.5% 113.9%
Uwh
50.6% 92.2%
This data illustrates one of the most well established phenomena in the world of Behavioural Economics, the Endowment Effect which suggests Managers add value when they are positive on a stock and lose value when they are negative.Having identified that Managers’ good decisions more than offset their poorerones when they are positive on a stock the next question is how persistent is thisphenomenon?The data indicates that if the ratio is favourable, or above 100 in any givenmonth, then it is 55.6% likely to be above 100 the next month. This may seem on theface of it a relatively low probability, but given the extensive size of the population,the result is highly statistically significant.The complete data is as follows:
fw mh
W lss r
Above 100 Below 100
abv 100
56% 44%
Bw 100
47% 53%
These results demonstrate that these measures get closer to the heart of thequestion of whether a Manager has skill and if it persistent.
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This process of identifying each decision a Manager takes and systematicallyevaluating whether they were successful or not, elevates our understanding of thenature of investment skill. By standing back from the noise, and looking at the coldevidence, we can see what managers are good at and where their gaps lie.Our experience, and the feedback from our clients, strongly suggests that thiseffort to identify and quantify investment skill is worthwhile. Investment managers,in turn, are able to really examine their strengths and weaknesses. Both are equallyimportant if they want to improve and refine their investment process. We shall see in the following section how GLG uses the analysis to provideobjective feedback to their Managers and traders as part of the process of continualimprovement.
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