Our new paper describes the relationship between investment skill and returns – and could revolutionize portfolio manager evaluation.
By Clare Flynn Levy
Clare Flynn Levy is CEO & Founder of Essentia Analytics. Prior to setting up Essentia, she spent ten years as a fund manager, in both active equity (running over $1B of pension funds for Deutsche Asset Management), and hedge (as founder and CIO of Avocet Capital Management, a specialist tech fund manager).
It makes intuitive sense: an investor who consistently makes good investment decisions should outperform one who doesn’t. But a statistically significant link between decision-making quality and investment returns has never been established — until now.
Our new paper defines a statistically-significant link between investment decision making and portfolio returns — current and into the future.
Essentia’s research team — which, over the last decade, has produced some of the investment industry’s pioneering work on investment decision-making — has long been on the lookout for a definable link between decision quality and portfolio returns. Their latest research contains two key findings:
- A statistically significant relationship between decision-making skill and returns (as measured by the Fama-French 3- and 5-factor models commonly used in portfolio performance attribution); and
- A temporal relationship between the two: an active equity fund manager who has made skilled decisions over the last year is 1.5 times more likely to outperform their benchmark over the next 12 months than a manager who hasn’t.
I am pleased to share our new paper, Actions Speak Louder Than (Past) Performance: The Relationship Between Professional Investors’ Decision-Making Skill and Portfolio Returns, now available for free download on the SSRN academic research database.
The implications of this new work are enormous. It gives managers and allocators alike an important new and rigorously-tested lens through which to evaluate a portfolio manager’s performance – and a way to better distinguish luck from skill in their returns.
Moreover, it makes it possible to tell whether a manager is more or less likely than other managers to deliver on their intentions of outperformance in the foreseeable future. This does not contradict the old adage of “past performance is not indicative of future returns”; in fact, it actually confirms that statement. But it uncovers a valuable new way to quantitatively compare equity managers and their relative probability of outperformance.
This is no doubt going to be the topic of further research, debate and development in the months and years to come; I am proud that Essentia is leading the discussion.
