How do you show investors your prudence and discipline in managing their capital when your performance-based metrics don’t tell a great story? First in a series (read part two).
By Doug Dundas
Doug Dundas is Chief Marketing Officer of Essentia Analytics. Prior to Essentia, Doug led investment research and communications teams at Citigroup and Goldman Sachs, following an early career in journalism at S&P/Businessweek, Money Magazine, and ABC News.
Difficult times are not boring. And if you have been an active equity portfolio manager over the past three years, you’re probably ready for the excitement to simmer down, so you can get back to some semblance of stability — if not sanity.
But what do you tell your investors to show them you have been prudent and disciplined in your management of their capital when your performance-based metrics just don’t tell a great story?
They’ll understand that the last few years weren’t your fault, but you’re going to have to explain yourself anyway. You need to show them that you behaved professionally and consistent with the process they hired you for. They need to know that you’ve identified any shortcomings in your decision-making, and you have a plan to address them going forward.
That’s the issue: you probably don’t have the tools to effectively do that. Traditional performance analytics — even the most sophisticated ones — rely heavily (if not solely) on past return data, which is often compromised by the random effects of luck.
And luck, in recent years, has probably not worked in your favor.
Enter decision attribution analytics — which enable you to tell the story of your performance, in any market, based on the quality of your decision making, distinct from your historical return figures.
Here’s a simple example, taken from our own decision attribution analytics-based framework and looking back over the past three years (through Q4 2022). A difficult period, to say the least. This large-cap equity manager underperformed, as many managers did. But decision analytics enable him to drill down into his decision-making process to see what he did that added — or destroyed — value.
This Behavioral Alpha Frontier diagram shows that he actually performed very well versus his peers at stock picking during this period (his payoff of 168% shows that his winning stock picking decisions added significantly more value than his losing decisions destroyed).
That’s the good news.
The bad news arises around his exit timing — well under his peers during this period, and his hit rate shows his exit timing decisions were “right” (that is, they added value) just 40% of the time:
That’s not necessarily a happy message for this portfolio manager to deliver, but it is a clear message, which his investors appreciated. And, unlike the market turbulence (i.e., the bad luck) that contributed heavily to his poor return performance, it is a factor that he can control — in fact, in this case, he had already undertaken a concerted effort to help correct his persistent habit to hold on to his winning positions too long (turns out this is an issue shared by many portfolio managers). By the time he reported to his investors, he could show improvement in this area in his more current data.
That’s one of the most compelling reasons for a portfolio manager to incorporate decision analytics into their performance review discussions: these are factors that, once identified, the manager has the power to change … and improve.
At Essentia, our business is decision attribution analytics, and we work with portfolio managers and allocators of capital every day to assess, understand, and optimize investment decision-making. Learn more about how we do this, and don’t hesitate to contact us if you wish to discuss it directly.
