Skill is the combination of the manager's expert judgment and investment processes.
When judgment and processes are well calibrated, great choices prevail, supporting the delivery of excess returns. When either element is off, the choices made may feel right, but they frequently destroy alpha rather than add to it.
Judgment and processes can only be studied by examining the decisions made by the manager. Consider this example: A value manager's new buys reflect a classic factor signature. When compared to their sector peers, the typical new buys tended to exhibit below-median price/book, above-median margin growth, below-median leverage, and above-median price momentum.
Performing the same analysis separately on the fund's buys that became winners and those that became losers provides surprising and valuable insights. The winners had below-median price/book but were not as cheap as the losers. The winners clearly had stronger balance sheets than the losers. The winners had strong margin growth, while the losers often exhibited flat or declining margin growth. The winners also showed positive price momentum while the losers experienced price declines.
Feedback like this transforms skill assessment and improvement from a guessing game to a highly rigorous process. It not only helps managers become more self-aware and improve, it's also being used today by asset owners/allocators to vet new equity managers and work more effectively with existing allocations.
It's worth noting that one of the drivers of the active ETF movement is the simple fact that many investors remain committed to active management — they are merely casting around for a more economic packaging. Lowering fees is not the only option. Stronger, more consistent results can also serve this purpose. The latter approach offers the dual benefits of satisfying investor desires (i.e., alpha at a reasonable fee) while also providing the revenues and margins that will enable active management to not merely exist, but to flourish.
We see a future of promise for the active asset management community. It all comes down to understanding, developing, and applying skill. And that requires the shift in thinking mentioned together with action. This results in a deliberate approach to improving that relies on rigorous feedback regarding which current judgments and processes are working and which need refinement; the implementation of modest process shifts that are likely to improve the level and consistency of fund alpha; and assessing how effective the shifts are in delivering the desired improvements.
Done right, 2024 and beyond can be one great comeback.
Michael A. Ervolini is a distinguished fellow, decision science and portfolio management, at FactSet. He is based in Boston. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.