Introducing the Behavioral Alpha Benchmark

It’s time to consider the quality of a portfolio manager’s decisions — not just near-term performance.

By Clare Flynn Levy

The investment management industry has a performance measurement problem. On the one hand, the footnotes of every investment ad disclose that historical performance is no guarantee of future returns. On the other, assets have very predictably chased performance since the dawn of investing.

But performance is not a measure of investment skill — it’s a measure of outcome. And while performance is a function of skill, it’s also a function of luck. In allocating capital to asset managers, investors should be paying for skill, not luck. So why do we base manager selection decisions on one to five-year performance, which is almost always affected by — if not dominated by — luck?

It’s because that’s all that has been available — until now.

Essentia Analytics has been helping active equity portfolio managers make measurably better decisions for nearly a decade. Using high-granularity investment activity data rather than fund performance figures, we’ve honed in on a methodology for skill assessment that has been used by hundreds of equity portfolio managers around the world: the Essentia Behavioral Alpha Benchmark (read our September 15 press release announcing this program).

By using the skill lens of our Behavioral Alpha Benchmark, a portfolio manager, his or her firm, or the portfolio’s end investors can gain insight into whether poor (or strong) performance is due to luck or skill.

With this game-changing tool, we hope to usher in a new era of manager assessment in the investment management industry. Portfolio managers can now unlock the means to continuous improvement, and investors and allocators can select the best, most-skilled managers for their capital.

In our latest research paper, we explain the methodology behind the Behavioral Alpha Benchmark and use it to measure seven key skills of 76 anonymized active equity portfolio managers over the past three years: stock picking, entry timing, sizing, scaling in, size adjusting, scaling out, and exit timing.

Overall, we found that while the managers’ decisions added value to the portfolio slightly less than half the time — consistent with the popular notion that active managers tend to underperform passive index funds — many managers outperformed their indexes and most showed particular strength in stock picking.

The top five managers in the assessment agreed to be identified and are named Behavioral Alpha^® Award winners.