How to pick the best from the rest
Everyone wants to know who the best fund managers are, and even more importantly, whether they’ll continue to do well in the future. Yet current measures for evaluating managers suggest few can sustain good returns year on year. Only a tiny percentage of fund managers consistently outperform standard benchmarks such as the FTSE All-Share index or S&P 500. This has led many observers to conclude there is little skill involved and it is just down to luck whether traders do well or not.
But Professor Narayan Naik, Academic Director of our Strategic Investment Management programme, thinks the traditional models based on managers’ past performance are not good enough. He has been developing new analytical models that get closer to the skill involved in trading, based on more information about what managers actually do – such as the number of buy and sell trades they make and the size of their trades. His latest research almost doubles one’s chances of picking good managers for the future and lifts the lid on the way the financial industry works.
Developing a new skill metric
It was purely a chance conversation with investment consultant Rick Di Mascio while travelling seven floors in a lift in London’s financial district of Canary Wharf, that gave Naik the idea for his latest research. Di Mascio’s company, Inalytics provides a unique database of $1.8 trillion worth of daily trades for over 750 institutional portfolios spanning all major regions and runs from 2001 to 2012, along with the benchmarks managers are asked to outperform.
Professor Naik and his PhD student, Anton Lines, who serves as teaching assistant on the programme, have used the data provided by Inalytics to develop a new skill metric relating the size of a trade to the likelihood the decision will turn out to be correct.
Getting it right and going big
They have found the best way to predict future success is to find managers who carry out successful large trades and plenty of them. The logic being that the only way to outperform a benchmark index is to take positions which are different from the index, to make trades and take risks. At the same time, making large trades is a sign of confidence – if you think a stock is going to do well, then you want to have a lot of it. So, one want managers who make large trades that are successful. Professor Naik’s research indicates that while the average manager is unskilled, approximately 10 per cent of managers can be identified as persistently skilled using this metric.
Fund managers have told Naik that these are the kind of metrics investment companies themselves use to reward manager performance, but they typically don’t share this information externally - perhaps because it shows managers’ limitations as much as their successes. Despite being pleased with his findings, Naik says he has to remind people that this is not a cast iron guarantee their manager will continue to outperform the benchmark: “When I end my presentation, I always say that with active management, you do your best in terms of manager selection, but then you still have to pray a lot.”