Manager selection is a bit of a dark art, according to the Australian Retirement Trust, as conventional statistical methods fail to give a definitive answer on the question of investment skill.
The investment industry is generally associated with cool-headed professionals who rely on verifiable data to make their decisions.
But selecting the right fund manager for your portfolio isn’t an exact science, Peter Barany, Senior Portfolio Manager at the Australian Retirement Trust (ART), said in a presentation for financial planners last week.
Barany argued that ultimately manager research is really about finding investment skill and the presence of skill is hard to prove.
He illustrated his argument with a statistical test of significance, or T-test. A T-test determines how two sets of data are related and whether there is a statistically significant effect present.
This test can be applied to compare a fund manager’s track record to their benchmark to see if their performance is the result of a fluke or whether a more sustainable trend can be observed.
But it takes time to do that, Barany said.
“Take a big data set, so a data set of US equity managers. Those managers have a standard deviation of 6 per cent … and a 2 per cent alpha expectation. How many years of history would you need to be 95 per cent confident that there’s some observable level of skill?” he asked the audience.
The answer is 63 years.
“You need 36 years of actual data and then you might be data mining those 36 years or something might have happened in those 36 years that led to that outcome by random chance. So you need another 27 years of what we call out-of-sample data,” Barany said.
“So a total of 63 years to be 95 per cent confident that there is some level of skill in those two data sets, that there’s some alpha.
“Once you’re sort of confident that you’ve identified a manager based on 63 years of data, that manager might be probably retired in their Tuscan villa or they’re probably dead.
“In our search for investing skills, we now know that we can’t rely on the science. We can’t rely on the numerical history because we don’t have the patience to look at 63 years.
“We need to bring in the art part of analysis.”
[It is about] trying to judge the quality of an investment manager using a number of different factors so you can put yourself on the right side of the probability that you may be able to get that alpha prediction right more times than you get it wrong, because you're going to get it wrong every now and then
Instead, Barany tries to skew the probability of finding a good fund manager in his favour by looking at not only quantitative, but also qualitative factors. These include a large set of metrics that look at the fund manager’s culture, the quality of their team and how long they have been working together, how strong their decision-making processes are and what their ambitions are.
Then he looks at strategy and tries to determine whether a manager has a competitive edge. What makes them unique? Sometimes that can be an informational advantage or an analytical advantage.
Perhaps they act differently upon receiving certain data.
Then he looks at a manager’s research process. How repeatable is it? Is it a team decision-making process or is it a star portfolio manager that’s making all the decisions?
Barany also looks at risk management and governance processes because ultimately a lot can be learned about the sustainability of a firm from the quality of the business and the personalities of the main portfolio managers involved.
“[It is about] trying to judge the quality of an investment manager using a number of different factors so you can put yourself on the right side of the probability that you may be able to get that alpha prediction right more times than you get it wrong, because you’re going to get it wrong every now and then,” he explained.
Judging the environment in which a portfolio manager works is key to their success. Barany still remembers one of his mentors saying to him in his earlier years: “It doesn’t matter how good the investor is or how good their investment process is. If the place where they ply their trade isn’t of high quality, they’re not going to be around in a few years. It’s not going to be sustainable.”
That lesson still rings true, he said.
__________
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.