Recently Michael Ervolini, director of strategy at FactSet, and founder of Cabot Investment Technology, a FactSet company, spoke with WatersTechnology about how asset owners are leveraging their metrics to give them an enhanced understanding of their external managers and greater confidence in their allocations.
The Importance of Active Equity Management
Institutional and retail investors allocate enormous sums to active equity management. Last year, active equities made up €318 billion in assets under management (AUM) in North America alone. But passive equities have dominated in the U.S. for some years and look set to overtake equities worldwide. There is an increasing tendency for asset owners to avoid allocating to active equities, as they have more confidence in passive products. That is understandable but may not be the right fiduciary response.
Investors struggle to understand how skilled their active equity managers are. Traditional analytics don’t measure skill. Instead, they measure how portfolio composition impacts returns. Ervolini says, “The absence of skill measures in active equities has prevented managers from achieving their best results and has made the allocation process for investors unnecessarily difficult.”
Because of their lack of confidence in these allocations, asset owners tend to switch to the most popular manager of the moment. But it is very disruptive and expensive to reallocate from one manager to another. “Having more conviction in long-term allocations benefits the active industry and the asset owners,” says Ervolini. “To have a strong and vibrant active equity industry, asset owners need to really understand the managers they’re allocating their money to.”
To have a strong and vibrant active equity industry, asset owners need to really understand the managers they’re allocating their money to.
This resonates with the asset owners Ervolini has spoken with. “They know they need to have an allocation to active equity as part of overall portfolio diversification, but they are not sure they are always making the best decisions they can.”
Knowledge Is Power
Giving asset owners and consultants a stronger understanding can reduce uncertainty and angst around investing in active equities. In addition to understanding the returns and other performance measurements of equity products, they need to have a better understanding of the skills that are driving those results. That means knowing, at a granular level, how skilled a manager is at buying and selling stocks. And they need to be able to differentiate between a manager that is currently successful, merely because of buying a handful of great stocks five or six years ago, and those that are consistently successful.
Having analyzed more than 4 trillion assets across hundreds of portfolios, Cabot observed that, in addition to a successful track record of between three and five years of outperformance, two other characteristics are closely correlated with future outperformance: very strong buying skills and consistent buying processes. “When a manager is not only buying good stocks consistently but buying stocks with a certain signature, you know the manager has built a process that gives them repeatable decisions, which, in turn, can lead to repeatable results,” says Ervolini.
When a manager is not only buying good stocks consistently but buying stocks with a certain signature, you know the manager has built a process that gives them repeatable decisions.
Those repeatable results strongly suggest future outperformance, and this information can offer asset owners more confidence in their allocations than traditional analytics alone.
Quantifying Managers’ Skills
Whereas traditional analytics focus on portfolio composition to describe sources of alpha, Cabot’s experience shows that asset owners should focus on decisions that can quantify managers’ skills. This then measures the strength of a manager’s buying, selling, and sizing decisions, and computes the consistency of the manager’s buying process. This looks at actions taken by the manager over time and uses these data points to quantify skills.
Asset owners should focus on decisions that can quantify managers’ skills.
This does not require a complete list of executed trades but analyzes daily holdings since, in Cabot’s methodology, an action is defined as a change in a position’s weight that cannot be explained by price movements alone. Applying this definition, it is easy to observe a buy with an active weight that exceeds zero, a sell with an active weight equal to or less than zero, and an add or trim with either positive or negative actions for active positions. Not only does this approach focus the analytics on the strategic decisions made by the manager, but it also handles flows elegantly.
Next, each type of action (buy, sell, add/trim) is assessed individually using a counterfactual portfolio. The counterfactual begins with the actual portfolio and then makes specific adjustments to extract the desired insight. The results of the counterfactual portfolio are compared with the actual portfolio to quantify each skill using purposely designed counterfactuals (buying, selling, sizing).
Using this technology and methodology, which has been available for 16 years, asset managers can be more self-aware and identify areas for improvement. Now, asset owners and allocators are looking to these metrics to give them an enhanced understanding of their external managers and greater confidence in their allocations. This creates a more level playing field for asset managers and asset owners and ultimately strengthens the industry.
Learn more about how asset owners can improve their allocations with Cabot.
This article was originally published on the WatersTechnology website.
This blog post has been written by a third-party contributor and does not necessarily reflect the opinion of FactSet. The information contained in this blog post is not legal, tax, or investment advice. FactSet does not endorse or recommend any investments and assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained in this article.