Evaluating and Selecting Active Investment Managers Based on Skill

Emmett Maguire III, CFA® BY: Emmett Maguire III, CFA® 11.20.17

What Makes an Active Manager Skilled

It’s easy to recognize skill. When an individual does something well, whether it be playing golf or knowing all the answers on Jeopardy, you can see they are skilled.

The deeper question is what defines their skill? What makes them so effective on the golf course? And how does the assessment of their skill change when you add or subtract other skilled individuals from the equation?

When it comes to building a portfolio using active management, skill plays a big role. In my last article, I discussed how success in selecting active investment managers is rooted in three conditions; one of which was good “fishing holes”, or identifying the markets with the most opportunity.

Doing so requires skill–but identifying that skill means understanding it first.

The Two Types of Skill

At Lake Street Advisors, the definition of skill starts with a distinction between absolute skill (examination of skill in isolation) and relative skill (examination of skill in relation to others). It would be hard to argue that Jon Lester, the former Red Sox and current Cubs lefthander, is not exceptionally talented when it comes to throwing a baseball. Absent other information, the casual fan would probably recognize him as an MLB pitcher, acknowledge that it’s a rare achievement, and agree he is a very skilled pitcher. This is assessing skill in isolation.

Now, if you were building a pitching staff for an MLB team, it’s highly unlikely you would evaluate talent in this way. Your objective would be to assemble the best pitching staff from the pool of available pitchers to achieve the lowest possible ERA (or whatever your favorite pitching sabermetric may be). To do this, you’d have to make an evaluation on a relative basis. Based on the 2017 regular season, who was the better pitcher, Clayton Kershaw (2.31 ERA) or Jon Lester (4.33 ERA), post season aside? The data would indicate Kershaw was the more skilled pitcher, relative to Lester, and thus more valuable to your regular season pitching staff.

Applying Relative Skill to Active Portfolio Management

Assembling a portfolio of active investment managers is not all that different from building a pitching staff. It’s an assessment of the available options by evaluating relative skill.

The catch is that just like building a pitching staff, it’s not enough to look at a single data point as proof of skill. Just like looking only at past ERAs isn’t going to be the only considerederation when building a strong rotation, you cannot look only at what a manager has produced for returns.

You have to build conviction by understanding where the performance came from. As a savvy GM would evaluate velocity, movement, and command (the qualitative characteristics that produce low ERAs and make one pitcher better than another), manager selection should isolate and examine the aspects of an active manager that offer opportunities for a competitive edge, and subsequently lead to attractive returns over a long time horizon.

The Skill to Effectively Assess Active Managers

Ultimately, the work of active investment managers can be distilled down into the following broad categories:

Whether and how a manager chooses to execute on these categories and the resources used impacts their performance, and represents a potential opportunity to gain on the competition. Or, in other words, improve their relative skill.

Focusing on the “how” and “why” behind these broad categories sheds light on the repeatability of a manager’s process and the amount of effort expended in it’s overall design. Repeatability and deliberate design are not only desirable characteristics in isolation, but also improve insight into how a portfolio manager thinks and what their intrinsic motivations are.

If you are invested in an active manager because their returns for the past five years have been attractive, what are you going to do when they hit a pocket of underperformance? Without an understanding of how a strategy works and a thesis for why you are invested, how will you know if it’s time to sell or add?

To maintain conviction in a recommended active manager and ride out the ebbs and flows of performance over the long term, investors should focus on the manager’s competitive advantages and if they still exist.

By combining an emphasis on good fishing holes with attention to the skill that we believe offers a competitive edge, we gain conviction in our recommended managers–conviction we may not attain if we focus too heavily on performance.

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