Rick Di Mascio
Investment skill is the raison d’être of the asset management industry. Asset managers are paid to have it and their clients pay them for it.
Despite this, empirical evidence of its existence, and what it looks like in practice, up to now, has been sparse, to say the least.
We at Inalytics have filled that gap by drawing on our database of 1,064 unique portfolios with $8.4 trillion of trades (4.3 million orders) and 346,000 individual positions to research whether there are, in fact, winners and more importantly what it takes to win.
On the first question, “Are there winners?” or to put it another way “Is there skill out there?” the answer is categorically yes. In performance terms alone, the average alpha of these portfolios is 234 basis points per annum (bps p.a).
The rest of this piece discusses what they are doing to achieve it.
To shift gears away from the outcome to the decisions and processes that produced it, we use our proprietary technology — which is subject to a patent application — DECSIS™.
Here we focus on the real decisions that managers take every day; they decide through the research process what they want to own or not own. Then manage the position’s size mainly through the buying and selling decisions.
The question is: What part of this process adds value and which parts lose value?
The answer to the first part of the question screams off the page — research. It may come as a surprise but research or the sets of decisions that determine which stocks to own, constitutes 107 percent of total alpha. Yes, that’s more than the total outperformance of the portfolios in the database. This result isn’t just a small tilt away from the average; the more positive the alpha from research becomes, the more likely it is that the portfolio will be in the top quartile.
These results demonstrate the importance of research — it’s the cornerstone of any successful investment process.
So, what’s on the flip side? What typically loses value?
The answer is the sizing decisions and, in particular, the trades. Typically, managers are far too timid with respect to their winning positions. This manifests itself in the overwhelming tendency to sell winners too early.
In fact, the average loss is a highly significant 53 bps p.a. This was highlighted in the influential behavioral finance academic paper, “Selling Fast, Buying Slow,” published in The Journal of Finance, which I am an author of along with co-authors from MIT and the University of Chicago Booth School of Business.
There may be other good reasons for selling winners early, but generating alpha isn’t one of them.
To summarize, investment skill does exist, it can be measured, and its true source is research.
(Author Rick Di Mascio is the founder and chief executive of Inalytics, a company specializing in identifying investment skills for asset owners and managers in 14 countries. Before establishing Inalytics, Di Mascico held several senior positions including chief investment officer of £25 billion coal schemes at the British Coal Pension Fund and at Goldman Sachs Asset Management. He is also a well-known author of respected research papers, including the influential behavioral finance academic paper that was published in The Journal of Finance, “Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors.” Klakow Akepanidtaworn, Alex Imas, and Lawrence D.W. Schmidt were the co-authors of the article, which can be found here: https://doi.org/10.1111/jofi.13271
Inalytics is also a presentation sponsor at the 2024 FTF Performance Measurement & Client Reporting event in NYC on Feb. 29th. Attend the event to hear Kate Land, lead data scientist for Inalytics, delve into this topic further.)
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