Essentia Blog

Show me the continuous improvement

– An allocator’s perspective on behavioral analysis

By Emmett Maguire III | 3rd October 2017

Emmet Maguire III, CFA is Investment Director at Lake Street Advisors, LLC in Boston. He is not affiliated with Essentia Analytics.

As an allocator with many years of experience, I’ve seen hundreds of equity strategies – in every flavor and size.  

Truth be told, once you’ve accounted for the different style and market cap biases (which can anyway be accessed via much cheaper passive vehicles), you’re left with a fairly homogenous group of experts in terms of idea generation and analysis.  

This makes it a huge challenge to find an active strategy that one believes has high odds of outperformance.

Ultimately, that conviction comes from identifying a team that possesses a demonstrable competitive edge. That edge can manifest itself in a variety of ways, most of which can be categorized as informational, analytical or behavioral.

To unearth competitive advantage, I strive to answer a number of key questions during the diligence process:

  1. Does the manager have better or unique information relative to their peers in a given market?
  2. Does the manager have a better team and/or a better method for analyzing the information they collect?
  3. Does the manager proactively identify and minimize mistakes stemming from the cognitive biases that all investors are subject to?
  4. Is there a philosophy of continuous improvement at work in the manager’s approach to their investment process?

As markets have matured, regulation has intensified, the number of CFAs has ballooned, and both processing power and data have become commoditized, it has become progressively harder to find teams with better information (question #1) or better research brains and processes (question #2).

In this context, investment in better information and smarter people has largely fallen victim to the law of diminishing returns – it’s no longer enough of a differentiator.

Putting behavioral finance to work

One remaining source of competitive advantage lies in the answer to question #3: Is the manager proactively identifying and minimizing mistakes that stem from cognitive bias?

Despite the increasing attention given to behavioral finance over the last decade, the integration of this knowledge has been disappointing, from an allocator’s point of view.  

It’s no longer news that all active equity managers display some form of bias in their investment decision-making. Some managers have taken steps in their research processes to attempt to address that.

But how do they know their efforts work? Can they quantify the impact that mitigating bias has had (or could have) on their performance?

Answering these questions, and moving beyond awareness to proactive management of these behavioral factors on a day-to-day basis, is not only possible – it can directly impact a manager’s performance for the better.

No rest for the active

But there’s no need for managers to stop there. Allocators like me are increasingly interested to see how self-evaluation at the individual level can be applied to team-level processes.

This is what lies behind question #4: Is there a philosophy of continuous improvement at work in the manager’s approach to their investment process?

I’m not referring here to the Brinson attribution that the vast majority of active equity managers use to explain what helped or hurt performance over a quarter or year. In my experience, this analysis never leads to positive behavioral change.

What I’m really looking for is evidence that a manager is proactively searching for aspects of the investment process that are potentially detracting from performance. That involves honest self-reflection, measurement of impact, and demonstrable efforts to adjust the investment process to play to strengths while minimizing weaknesses.   

I am interested in managers who ask themselves questions like:

  1. Have we been successful when investing in IPOs, or should we stop doing it?
  2. Do our starter (toe-hold, farm team, whatever your name for them is) positions add or detract from portfolio performance? Would it make more sense to have more concentration and/or bigger starter positions?
  3. Does “trading around” positions add to our performance and help us achieve our portfolio’s overall objective?

And I want to see data that proves the answer – not because I don’t trust the manager, but because I know that without data, there is only speculation.

Picking is only part of the process

Most equity PMs are hyper-focused on stock selection and many claim to be ‘great stock pickers’. However, the problem with this emphasis on stock picking is that it de-emphasizes the other components of the investment decision-making process. The reality is, there’s no such thing as a strategy where timing and sizing decisions don’t matter.

A disproportionate focus of energy on idea generation implies that a manager still believes that they can have significantly better information, or better methods for analyzing that information, than their competition.

But as has been the story in so many other fields before ours, I believe that an active manager’s biggest competition today comes from those investment teams that are creating real differentiation at the process level – and a recognition that stock picking is just one part of that process. This creates an existential need for adaptation and continuous improvement for every player.  

As an allocator, I’m looking for evidence that a manager sees this reality and is doing something to embrace it.

And now the good news

For those managers who prepared to look in the ‘data mirror’ with the intention of continuously improving, the immediate future is actually bright, thanks to the new generation of behavioral data analysis.

It used to be extremely time-consuming and resource intensive for a portfolio manager to explore and assess their investment behavior at a personal and process level. That’s no longer the case: behavioral data analytics makes it possible to shine a light on the human drivers of investment performance, to uncover the ‘Behavioral Alpha’ that comes from mitigating bias, and to measure continuous improvement.

When I hear that a manager is investing in ‘alternative data sets’, I can’t help but think “You and everyone else!”.

But when I hear that a manager is working with Essentia Analytics, I take note. I know Essentia analyzes the manager’s track record trade by trade – in the context of their unique investment process – and delivers unbiased, data-driven feedback. A manager who’s armed with that still has a competitive edge, in my book.

Conclusion

Competition in investment management has never been more intense – and there’s no reason to believe that will abate. As an allocator, I’m looking for managers who are making demonstrable, data-driven efforts to continuously improve, and creating true competitive advantage in the process.

To see how Essentia helped one active manager to mitigate behavioral factors and refine his investment process, download our free case study.

2017-10-04T10:31:50+00:00